In a note from November 1, Nomura economist Richard Koo explained one of the problems facing Europe in the way of the October 26 summit agreement…
Problem 1: no measures to ease credit crunch
Having considered the positive aspects of the agreement reached on October 26, I would now like to discuss two major shortcomings. First, the plan contains no measures to address the credit crunch that is likely to result when a 50% haircut is combined with substantially higher minimum capital ratios for the banks.
As I argued in my last report, great care must be taken to prevent a credit contraction in the current circumstance. If support for Greek growth in the form of debt forgiveness coupled with tougher capital rules causes European banks to stop lending, the eurozone economy will be the victim of these policy initiatives.
Unfortunately, this issue is addressed in just one line of the 15-page document, and all it says is that
“National supervisors must ensure that banks’ recapitalization plans do not lead to excess deleveraging.”
The lack of any mention of how supervisors are supposed to prevent this outcome suggests a complete lack of understanding among those who drew up the agreement. This is because this is not an issue that can be resolved by national bank inspectors.
Banks will try to raise capital ratios by deleveraging, not raising fresh capital
This discussion overlaps with points made in my last report. The new agreement calls for banks to maintain a core Tier 1 capital ratio of 9%. But with so many lenders facing the same problem, it will not be easy for individual institutions to raise their capital ratios to the required level.
And even if it were possible, fresh capital could be very costly, further increasing the burden on banks.
Under such conditions banks are more likely to comply with the 9% rule by deleveraging than by raising new capital. In some cases, at least, shrinking the balance sheet will do more for the bank’s financial health than raising costly additional capital.
Shrinking the balance sheet is synonymous with calling in loans. While that would present no problem if carried out by only one or two institutions, it could trigger a sharp credit crunch in the broader economy if the entire banking sector goes down that road.
This is exactly what Unicredit announced today:
AROUND 11% OF JUNE 2011 GROUP RWA RINGFENCED AND RUN-OFF TO SUPPORT THE BEST CAPITAL EFFICIENCY
…Proactive balance sheet management and ring-fencing of non-core performing assets in a €43bn (RWA) run-off portfolio. With around 80% of the portfolio expected to run-off by 2015, the ring-fencing initiative will free-up substantial capital and liquidity during the Plan’s implementation period
In other words, Unicredit is going to massively reduce its risk in an attempt to meet capital and liquidity.
It’s almost certain that Unicredit won’t be the last, and so there’s about to be a big vortex sucking credit out of Europe.
If you didn’t think a recession was coming, you should now.