Opinion

James Saft

Europe’s coming credit austerity

October 18, 2011

By Jim Saft
James Saft is a Reuters columnist. The opinions expressed are his own.

Having demonstrated how poorly austerity worked in Greece, Europe may be on the verge of giving it a try in credit markets.

Plans to rescue the euro zone and its banks might land Europe in an extended credit crunch, a very poor outcome given the continent’s continued heavy reliance on bank financing.

While details are depressingly vague as to the how, plans seem afoot to insist on widespread recapitalization in European banks as part of an overall financial crisis package. The idea, broadly, is that the euro zone will write down Greek debt sufficiently, while establishing a backstop to stop a run on other weak states’ debt and then recapitalize the banks so that they can withstand the losses inherent in the exercise.

The U.S. banking recapitalization of 2009 is widely viewed as the model here, if not in form then in outcome, as U.S. banks are now far better capitalized than their European peers.

There are, at least, two severe problems with this.

Firstly, a look at the U.S. will show that while its banks as independent entities were saved, their ability to play their role in intermediating capital was compromised, at least in part because they were not aggressive enough in writing down doubtful housing-related debts. That’s an important contributing factor in creating a frail, shaky recovery in the U.S., and could easily happen in Europe.

“Markets may also fear adverse unintended consequences; for example, proposals to strengthen bank capital ratios that banks try to meet by accelerating the shrinkage of balance sheets,” George Magnus, senior economic advisor at UBS, wrote in a note to clients.

“This would deepen the euro zone’s growth crisis and make higher capital ratio goals retreat ever further into the distance.”

Europe, like the U.S., is going through a balance sheet recession. That means everyone is trying to repay debts at the same time, suppressing growth, inflation and asset prices. Government austerity is exacerbating this, but an extended credit crunch as banks try to rebuild balance sheets will only make matters worse.

This is not to say that Europe’s banks don’t need to shrink, as does its sovereign debt. Euro zone plans to save itself seem to have moved from simply trying to restore confidence, an impossibility as a stand-alone plan, to adding capital to the mix. Without addressing the underlying indebtedness this is going to result in either failure or a very extended period of slow growth.

WRITEDOWN NEEDED

An attempt to shore up banks must come to terms with the other over-indebted borrowers in the euro zone, and not simply the sovereign ones.

Take Spanish house owners, for example, who already face huge difficulties in getting loans to finance real estate purchases. Independent economist Edward Hugh argues that Spain needs a substantial asset writedown program, something that bank recapitalization simply does not address.

One easy-to-foresee risk post a euro zone rescue is that continued weakness in housing in peripheral markets continues to stress bank capital, casting a shadow over funding markets and undermining confidence. Remember, euro zone banks have a loan to deposit ratio of about 108 percent, a good 20 percentage points higher than U.S. banks, and only about 10 percent below their own pre-crisis peaks.

A reduction in bank lending in Europe is going to be even more painful than it would be in the U.S. given the euro zone’s less deep and highly developed capital markets. Europe has no Fannie Mae or Freddie Mac, yet, to take the strain in housing finance. Middle-sized businesses are still very reliant on bank financing.

In the U.S., the Federal Reserve helped to mitigate the pain of bank recapitalization by creating conditions in financial markets where investors wanted to take on some risk, leading to a booming market in bond issuance for corporate borrowers. Thus far there is no talk of credit easing from the ECB but it would not at all be surprising if this is on the agenda in a year’s time, once the force of bank deleveraging has been felt.

This is not an argument for going easy on banks, their shareholders or their executives. If anything Europe needs to take a harder line — forcing writedowns of debts public and private and being prepared to deal with the consequences.

Those consequences would not be pretty for bank shareholders. Many banks would fail and need to be taken into temporary public administration.

The more controlled default there is as part of the euro zone’s rescue, the better the results will be in two years time.

Comments
3 comments so far | RSS Comments RSS

Would politicians still be able to force banks to loan money to bad credits after the politicians forced the banks to eat the bad debt on their books?

Would politicians be force to discontinue the practice of implementing social welfare programs that were not paid for in order to buy votes?

It appears that you are arguing for banks and their shareholders to absorb the pain for the out of control spending of sovereigns. Apparently you think the banks made a mistake when the bought Greek bonds. Didn’t governments encourage banks to buy their debt by giving the illusion they would never default on it? Pehaps taxes should be raised and benefits cut so that govenments can actually repay the debt they took on.

Posted by DiegoForever | Report as abusive
 

A little off the subject, but I would make the case too many in all countries are now working under the table! A flat/fair taxation scenario like the 999 plan IS THE SOLUTION folks-KISS! In the US, we pretend a 65,000 page tax code works with 10s of thousands of high paid IRS-whast’s wrong with this picture?? I’d say this is as much an injustice as anything else-favors the rich, lacks transperancy and encourages dishonesty!

Posted by DrJJJJ | Report as abusive
 

It seems hard to imagine that Greece (State and/or people)does not have substantial assets (many of which are probably unproductive) that could not be used to alleviate its liabilities. Why are such assets not transferred (avoiding fire sale) to it creditors? Does anyone have a handle on the value of these assets. It would seem unreasonable to have a right down of debts before the transfer of these assets is exhausted.

Posted by I_R_Responsible | Report as abusive
 

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