Richard Koo On The Biggest Blunder That’s Still Being Made In Europe

richard koo

There’s a brand new note out from Nomura’s Richard Koo, much of which is a rundown of some his big ideas and the big themes of the past several weeks (it’s been a while since he’s written anything).

Based on the falling yields in Italy and Spain, he declares the ECB’s 3-year LTRO a success, though he warns that there’s a big difference between propping up the financial system and rescuing the economy, which the ECB decidedly will not do.

What he sees as a major blunder if the ECB’s new capital rules, which will guarantee a credit crunch.

Here’s that section of the note


Biggest bottleneck: EBA’s tough new capital rules

The next question is, What is preventing the funds supplied by the ECB from flowing into the real economy and improving economic conditions? Although there are a number of answers, the biggest obstacle from a policy perspective is the European Banking Authority’s tough new capital rules.

The EBA has demanded that European banks raise core Tier 1 capital to 9% of risk-weighted assets by June 2012. None of the policies unveiled in response to the crisis has been so counterproductive.
A tightening of bank capital requirements would not create major problems in an ordinary world without a financial crisis. If only a handful of banks are in trouble, asking those institutions to raise more capital would not lead to major macro-level problems because other financial institutions would be willing to supply capital to those banks or increase lending in their place.

But with a financial crisis already in progress and the sector undergoing a systemic crisis, in which a majority of banks face the same problem, demanding higher capital ratios will trigger a destructive credit crunch, as I have argued previously.

This is because sources of additional capital during a systemic crisis are extremely limited, and for many institutions raising capital, if possible at all, can be very costly. Expensive capital, in turn, will only weaken these banks’ financial strength.

As a practical matter, the only way banks can satisfy the new capital requirements if raising capital is difficult is by reducing the denominator in the capital ratio: total assets. If all banks try to do that at the same time, the result will be a destructive credit crunch.

Adoption of BIS rules sparked severe Japanese credit crunch in 1997

Although Japan’s bubble burst in 1990, it was not until October 1997 that the economy experienced a serious credit contraction. The decision by the Ministry of Finance’s Banking Bureau to unveil the details of new BIS-based capital rules on 1 October that year—a time when most Japanese banks were struggling under the weight of bad debts—triggered a destructive credit crunch.

Discussions about the new BIS standards had been ongoing for a number of years, but it was the announcement of the specifics on new rules in October 1997, when the bubble’s collapse had left Japanese banks in an extremely weakened state, that prompted a major credit contraction.