Thursday, June 14, 2012

Room for manoeuvre: The deleveraging story of Eurozone banks since 2008

by Heiko Hesse, Claus Puhr, Stefan W. Schmitz and Ralph Spitzer


June 14, 2012

Europe’s heavily overleveraged banks are now under European Banking Authority orders to rapidly raise their capital-asset ratios. Many fear that this will trigger a contractionary shrinking of assets rather than prudential increases in capital. This column presents new evidence that these fears are unfounded. Eurozone banks have room for manoeuvre.

Investor trust in European banks has dwindled, first, in light of the economic and financial crisis, then, the European sovereign debt crisis and with it the worsening economic outlook. As tightening refinancing conditions for European banks spun out of control in summer and autumn 2011, the European Council agreed on a set of policy measures to address the pernicious triangle of sovereign debt, banking system health, and economic growth. Of all measures, the European Banking Authority’s (EBA ) recapitalisation exercise became the far most contested. Fears of a European-wide credit crunch, fuelled by banks shrinking their balance sheets, became policy priority number one (see BIS 2012 and IMF 2012a and 2012b).

On this site, Morris Goldstein has excoriated European policymakers and supervisors alike, for having defined the recapitalisation target in terms of a ratio to Risk Weighted Assets (RWA) rather in terms of absolute numbers (see Goldstein 2012). This would provide incentives for bank deleveraging “which is unambiguously contractionary”. While the risks of deleveraging are often prominently featured, the evidence so far is weaker and receives much less attention.

In this column we investigate balance-sheet growth, capitalisation, and deleveraging of European banks since the end of 2008 and show that based on existing empirical evidence banks have so far reduced their leverage (i) markedly and (ii) mainly by raising capital rather than reducing exposure to the real economy. In doing so, banks have been able to address two concerns at the same time: One related to their fundamental soundness (“banks are undercapitalised”), the other related to potential harm done to the economy at large (“banks are causing a credit crunch”).

Before we delve into the economic analysis and (available) quantitative evidence, let us define deleveraging as the reduction of leverage, i.e. a decrease in banks’ total-assets-to-capital ratios. Banks can achieve it by raising capital and/or shrinking total assets. Moreover, we refer to excessive deleveraging as a contraction of lending to the real economy to achieve deleveraging, such that creditworthy non-financials (companies and households) are credit constrained.


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