Europe’s banks must be forced to recapitalise now
Mohamed El-Erian
November24, 2011
Just when you think the European crisis cannot get much worse, Wednesday’s shunned Bund auction showed that it can. With this, the risks for the global economy as a whole, and for virtually every country, increase materially.
Given this week’s developments, there should be no doubt in anyone’s mind that what started out as a dislocation in the periphery of the eurozone has now decisively breached the firewalls protecting the outer core and is seriously threatening the inner core. Unless this is countered quickly, European policymakers will find it even harder to catch up with the crisis, let alone get ahead of it.
Europe must still stabilise its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.
In the eyes of the markets, the capital cushion of Europe’s banking system as a whole is no longer sufficient to support its balance sheet. This concern is not limited to the markets. Judging from their eagerness to dispose of assets, bank managements also believe that balance sheet delevering is key to the institutions’ survival and wellbeing.
In today’s environment, selling begets more selling; and it is not just about other unhealthy balance sheets also being forced to delever. The vast majority of healthy balance sheets -fortunately there are still a few - are reluctant to engage. Some are even taking risk off further, including those that believe that this enhances their relative market standing. It brings to mind the period of ”macho provisioning” by US banks during the Latin American crisis of the 1980s. Ironically, this may be intensified by Tuesday’s announcement that the Federal Reserve will impose another stress test on large American banks.
None of this helps liquidity management. Not surprisingly, a growing number of European banks are now either materially or wholly dependent on the European Central Bank and related facilities (such as the national emergency liquidity assistance programmes).
The situation is particularly acute for those that previously relied on wholesale funding, which has essentially disappeared, and those suffering deposit outflows, which are accelerating in very troubled countries such as Greece.
All this makes it very hard for the banking system to get back on side quickly, especially at a time when three other issues are making it difficult to manage balance sheet risk. First, traditional asset diversification no longer affords the same degree of risk mitigation given the scope and scale of the European crisis. Second, with historically low interest rates on government bonds issued by the strongest economies, such holdings offer only limited protection in today’s environment. Third, confidence in market-based hedging instruments, including credit default swaps, is eroding due to uncertainty about what will happen to them during major market dislocation.
Problems in the banking sector have a nasty habit of accelerating and amplifying crises. Indeed, they significantly increase the risk of policymakers losing control. It is therefore critical for Europe to add this policy challenge to an already long ‘to do’ list.
Europe must now go well beyond the steps proposed at the October 26 summit. In addition to specifying higher prudential capital ratios, governments must now bully banks to act immediately. Where private funding is not forthcoming, which should now be the presumption for a growing number of banks, recapitalisation must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared.
The urgent stabilisation and reform of the banking system is one of the five key areas that will determine the future of the eurozone. With little time to waste, success will also require progress on the other areas – namely, more appropriate reform programmes on the part of heavily-indebted economies, a better delineation between solvency and liquidity cases, more effective circuit breakers from the ECB, and decisions on the urgent strengthening of the institutional underpinning of the eurozone (as currently configured or in a smaller version).
Europe’s already long list of ‘must do’s’ is getting longer and harder by the day. Denial, obfuscation and further dithering by policymakers serves only to make the situation even more daunting, and the eurozone’s future more uncertain.
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The writer is the chief executive and co-chief investment officer of Pimco
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