In his latest note, Nomura’s Richard Koo takes on the latest EFSF agreement and actually… he sees a fair amount to like.
Now it should be noted that the note has a very pre-today feel in it, in that it assumes the whole thing hasn’t been blown up already, which it may very well have been.
What does he like about it? He likes the bigger bazooka, he likes the talk of bank guarantees, and he likes the acknowledgment that Greece needs growth, and that growth is the only way out.
Remember, in his note from October 18, he basically called on Europe to do a big no-strings attached bailout, much like America’s TARP.
So what are the two big problems?
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
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.
The other huge problem, essentially the same problem that the US faces…
Problem 2: balance sheet recession considerations completely ignored
The other key shortcoming of the agreement reached on October 26 is that European leaders appear oblivious to the possibility of balance sheet recessions. Consequently, the agreement does not make special consideration for countries in the midst of such recessions like Spain and Ireland.
In fact, the agreement demands further deficit-cutting efforts from Italy, Spain, Portugal, and Ireland, and explicitly calls for the creation of a powerful monitoring mechanism to ensure their compliance.
This body will be responsible for examining the budgets of these nations before they are passed into law and will have the right to express its views on those budgets.
The agreement also calls on eurozone members to pass balanced budget rules, preferably as amendments to their constitutions.
Although the requirement is for zero structural deficits, which suggests that cyclical deficits will be permitted to some extent, the rules must still be passed by the end of 2012.
Of course, this is Koo’s big hobby horse, so no surprise that he’s appalled at the lack of acknowledgment of this issue.
And of course, after today’s Greek horrorshow, whether the EFSF even exists at all is a diferrent matter.