Is the Eurobankster “We’ll Shrink Our Balance Sheets” Threat Largely Empty?

Even though the Greek move to blow up the latest Eurorescue plan caught the world’s attention, another pushback is underway, this via the blue chip lobbying group, The International Institute for Finance.

The threat, which has surfaced before and is picked up in an article by Bloomberg, is that raising capital levels as mandated under the latest version of the Eurorescue plan, won’t take place by selling equity, retaining earnings (which would almost certainly mean constraining pay levels) or accepting government equity injections (which will come with nasty strings attached). Instead, banks will just shrink to meet the targets by selling risky assets. (Note that the targets, which are being met with howls by the industry, are for them to write down sovereign and reach a core capital level of 9% by June 30, 2012).

This is meant to be a threat. “Shrinking assets” implies less lending. Less lending would put a downward pressure on economic growth. Recessionary or near recession conditions tend to lead voters to throw elected officials out. So this sabre rattling is clearly meant to get the officialdom back in line.

How seriously should we take this?

First, it’s likely that the June 30 timeframe would severely constrain the ability of banks to execute on this threat. Who exactly is going to buy these assets? Other, similarly situated banks won’t, at least not in sufficient size. Banks in most other advanced economies are also subject to “increase equity level” requirements, even if not as severe as those faced by the Eurobanks. Hedgies might, but we have an open question as to whether banks will be tightening terms on their prime brokerage lending (Deutsche Bank is one of the top four prime brokers). And even if they took some assets, they lack the capacity to take anywhere near enough. The Eurobanks’ total assets are 325% of GDP. Even changes at the margin add up to big numbers quickly.

Now the general rule of finance is everything can be solved by price, that if you lower prices enough, demand rises considerably. But the big banks are loss constrained. If they have to show much in the way of losses on the risky assets they are threatening to dump, the net effect would be to lower rather than increase equity to total asset ratios. And that’s before we get to the all-too-likely possibility that some of these assets are held at unrealistically high valuations. So that means you don’t even need market selling pressure to reveal losses; trying to unload some of these holding in a “normal” market would expose what Geithner called “air in the marks”. Remember, regulatory forbearance, otherwise known as extend and pretend, has been the name of the game.

Second, the banks really really don’t want to shrink either. Bank CEO pay is highly correlated with the asset size of the institution. And the risky assets they are threatening to dump are big profit drivers in good times, so getting rid of those would have an even bigger impact on reported bank profit and hence compensation of the top brass.

Third, with the Eurozone economy in low growth/near recession conditions, it isn’t clear that bank capacity is constraining lending. Businessmen don’t like to borrow for the fun of it, they do so to pursue profit opportunities. Unless a business is countercyclical or in a niche that is doing well, they don’t have strong reasons to be borrowing right now. And in the countries where housing bubbles were a big part of the debt explosion, mortgage debt is going to shrink over time.

Finally, cutting the banks down to size is necessary to end their looting. Gene Frieda argued (in economist code) that the Eurobanks’ business model was unsustainable in its current form and the banks needed to shrink by 50%. From his article:

Higher levels of capital are required for two main reasons. First, economic growth looks set to be much weaker than expected, meaning that capital buffers will need to be built. The European Banking Authority’s stress-test scenario from June looks more like the baseline scenario today. If traditional asset-quality considerations were the only problem buffeting eurozone banks, recapitalization would restore investor confidence, debt markets would reopen, and banks would find raising capital much cheaper than it is now. That isn’t happening, because the problem is growth.

Second, with the demise of sovereign-debt equality, eurozone banks will require higher capital-adequacy ratios to compensate for higher risk. Banks in emerging markets tend to carry higher capital buffers for a similar reason. Just as business and credit cycles there tend to be more frequent and extreme, the real possibility of de facto currency crises in the eurozone, owing to higher sovereign borrowing costs and slow adjustment to shocks under fixed exchange rates, renders massive balance sheets unsupportable and thus obsolete. Higher capital ratios are required today and, absent a credible sovereign safety net, in the future.

Thus the outcome that the IIF depicts as peril, that of making megabanks much smaller, is precisely where they need to go. The issue that should be argued isn’t whether or not the European banking system needs to shrink. It does. The question is how much and how quickly. The failure to put this issue front and center in policy formulation is likely to lead to inconsistent responses which may well play into the banksters’ hands.

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  1. F. Beard

    The question is how much and how quickly. Yves Smith

    The banking system should only be as large as it can exist without government privileges and after the population has been bailed out of all debt to it is the short answer.

    And just the threat that bankers will sabotage the economy to get their way should cause everyone to seriously question why we even need banks.

    1. gordon

      Thanks for that interesting post.

      Another option would be for Euro Govts. either separately or acting together to set up a new Govt.-owned bank, if it looked like lending might be constrained significantly.

  2. proximity1

    They can sell off their risky assets? Fine. Let them sell them, then. In doing so, they’ll discover how valuable those assets are and maybe take the losses they deserve in the process.

    The interested governments should reply: ‘Fine, sell the risky assets. Who’s stopping you anyway?’

    Note to the investment banking industry: MFGlobal wasn’t bailed out. Now your losses are your own to deal with. It’s high time the “hazard” was put back in “moral hazard”.

    1. psychohistorian

      IMO, the moral part of hazard should have been there back in 2008 I am sure that since then the global inherited rich have surely sequestered their wealth in safer positions. Its seems that more of the moral hazard is now on the backs of the public.

      1. proximity1

        psychohistorian says:
        November 2, 2011 at 7:32 pm
        IMO, the moral part of hazard should have been there back in 2008. I am sure that since then the global inherited rich have surely sequestered their wealth in safer positions.

        The key lesson of economics (and the one most consistently lost sight of) is that this supposed safety is always more or less illusory; investments always necessarily entail risks of loss and safety, refuges, hedges, are always relative in their value.

        These and other invaluable insights on how markets really work are brilliantly presented in an award-winning essay by Pierre-Noel GIRAUD, “Le commerce des promesses” (“The Marketplace of Promises” or “The Trade in Promises”),

        Grand Prize winner for Management & Strategy, 2001, and the Turgot Grand Prize for Financial Economics, this book foretold in 2001 the essential circumstances of the market crash(es) since its first appearance. As the author explains, we now have an system of international finance which depends for its actual “regulation” on frequent and catastrophic crashes. Unfortunatelym, no English translation is available at this time.

  3. rf

    Do you want the banks to loan these governments money or not? Maybe if they simply stopped rolling over maturities over the next year they would get smaller (just estimating off bloomberg, thats about 750 billion euros).

    Why is this a dishonest way to reduce the size of balance sheets and the need to raise equity? You want the bank to take less risk, then they should stop lending to the PIIGS?

    Of course this all matters little because the risk weight on government debt…

  4. Tom Mc Cool

    Notwithstanding that you have two “Third” points, if the second Third is for the banks to shrink, but they are loss constrained (true) but also demand deficient, how exactly do you suppose they can shrink?
    The riskiest debtors are most unlikely to repay in the short term, those same assets are likely unsaleable and selling the stuff that is par leaves the remainder a much higher risk set of assets. So, if shrink they must, what’s the plan? Divide and conquer?
    Logistically, the hard part of shrinking the banks is the retail network if it is consolidated on a single back office platform. It can be taken apart, but who takes it? De Novo banks? A set of currently smaller banks?

    1. Yves Smith Post author

      The banks are hugely levered and dependent on market funding (US money market funds, for instance). So the shrinkage comes in their assets and their use of market funds, not their deposits. So this should not impact retail branch networks.

      1. DP

        Why any investor would have even a dollar in a U.S. money market fund that isn’t invested 100% in U.S. government securities is beyond me. It is return free risk.

  5. RBHoughton

    I think there is a better approach.

    The main spring of government power is its ability to tax. When tax payments become a matter of choice, as they are with companies operating internationally, governments can only grovel and plead. Then the dynamic becomes ‘you give us ‘n’ dollars or we’ll make life unbearable for you.’ This is not the way to run a country.

    For governments to exercise sovereignty requires they have the ability to tax all their people. International trade is fine and welcome but international companies are clearly not. If ABC Bank, DEF Commodities or XYZ Minerals wish to trade overseas they should incorporate themselves in those foreign jurisdictions, comply with legal requirements of the host government and provide annual audits for its revenue.

    There should be no more subterfuge, no more complex transfers for plausible reasons, no more exemptions from the reasonable requirements of the host country.

    1. Nathanael

      The laws actually mostly work the way you want them to.

      The specific problem is the laws relating to “foreign-controlled” corporations and corporate subsidiaries. There are gigantic loopholes regarding transfers between corporations and their foreign subsidiaries which allow for most of the odd behavior — and the fact that most countries have eliminated capital controls (allowing foreign ownership) accounts for the rest.

      If board members of a company were required to submit themselves to personal jurisdiction in the country where the company was incorporated, and if board members were responsible (Roman style) for the actions of a company, that might be a substitute for the capital controls. As it is, we have neither capital controls nor responsibility on the part of the board of the subsidiary.

  6. Hugh

    Nice analysis. I agree that the two key questions are who would buy this drek and, dumping this all on the market quickly, doesn’t this sound like a correlate of debt deflation? Wouldn’t both the real low prices (mark to market valuations) and the price depressing effect of putting a bunch of assets on sale in a weak economic environment both singly and together expose the underlying insolvency of the banks?

  7. Hugh

    Nice analysis. I agree that the two key questions are who would buy this drek and, dumping this all on the market quickly, doesn’t this sound like a correlate of debt deflation? Wouldn’t both the real low prices (mark to market valuations) and the price depressing effect of putting a bunch of assets on sale in a weak economic environment both singly and together expose the underlying insolvency of the banks?

    Sorry if this repeats, my first comment seems to have disappeared.

  8. Jeff

    Not mentioned in your post, though inferred, is another number — 30%. That is the amount of core capital as a % of GDP that banks would require (.09*325). Just another way of portraying how ridiculously the size of the financial sector has been bloated by decades of state-sponsored moral hazard.

  9. Some Bloke

    We had this in Australia in the late 1980/90s. Banks lent anything you wanted on bullshit valuations, interest rates went to 20%, property prices then collapsed and so did bank share prices and some banks altogether.

    But of course, nobody could see any of this 2008+ disaster coming…..

  10. SH

    I doubt that when God created man he expected only three numbers to matter, GDP, unemployment and inflation. If he knew that was all that mattered he probably would not have messed around with morals.

  11. RT

    Money as a monopolized commodity in the hands of just a few extortive antisocial creatures who are proud to have invented a gigantic and opaque cheating and looting industry which enables them to materialize all their wrong personal incentives. I think they’ll try all they can to keep it that way.

    I wonder whether the MMT’ers are right. If they are then our times today may really be viewed as the biggest idiocy making possible the biggest perfect crime in history since most of what we’re living thru might be revealed by future historians as completely unnecessary. That’s a hard to grasp guess but is it wrong?

    We’ve learned in the past that the printing press doesn’t belong into the hands of reckless politicians. Now we’re learning that it also doesn’t belong into the hands of reckless bankers. It seem to be the task that we must find a third way, urgently. That way must be designed to successfully rule out that any self-interested group of individuals is able to put their hands on something that is an existential public good or commodity, especially such as money.

  12. Brick

    Bank CEO’s are not in the business of building a solid business but in short term renumeration and keeping the share holders happy. What happened to Dexia when it was told to shore up its capital.
    I can see a situation where banks sell of the assets that are really worth something like retail deposit institutions. After all they are steady money makers rather than providing exciting returns to investors. The banks would not reduce lending but change its focus from lending to the economy, to lending to the leveraged gamblers.
    You could end up with structurally unsound banks, that on paper have the appearance of boosted capital and profits. Banks now have 6 months to fiddle the books and I personally think it would have been better to just recapitalise the banks straight away. They have had over 2 years to sort things out and I see no reason to give them the extra six months.

    1. sleeper

      What the banks are threatening to do is to freeze the credit markets especially the commercial credit markets.
      This has been done in the past sucessfully during the Clinton administration and as an incentive to force the release of TARP funds. In fact Mr. Bloomberg of New York recently publically stated that the OWS folks should be careful or the bankers would stop loaning money.
      Two suggestions:
      1) Arrest, investigate, and prosecute the bankers and their minions for communicating threats (a felony in many states).
      2) Make arrangements to nationalize the commercial credit markets. Note that the mortgage market is effectively nationalized via Freddie and Fanny and that the Fed basically sets national interest rates.

  13. Praedor

    The answer to this sort of CRAP is to tell the banks that they WILL loan or they are not banks and will be nationalized/liquidated if they fail to be banks.

    In addition, they should all be treated as what they are: public utilities.

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