May 3, 2012 8:06 pm
Banking: That shrinking feeling
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Wally Bonvicini has had enough. The fashion entrepreneur is standing for mayor in her home town of Parma in northern Italy, and her campaign slogan is simple and to the point: “Against the banks.”
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“After 30 years as a businesswoman who used the banks, I suddenly realised [they] are usurers,” says an impassioned Ms Bonvicini. “I can live without banks. But if we’re not careful we’ll end up with no small companies in Italy.”
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It is a prospect Europe as a whole is starting to contemplate. From Parma to Paris, companies, consumers and governments are realising banks no longer have limitless financing capacity. Five years after the financial crisis hit the US and forced lenders there to shrink, Europe, too, is learning the meaning of “deleveraging”.
This is the process, in financial jargon, of unwinding excessive “leverage” – essentially the ratio of a bank’s assets, or loans, to its equity capital. In the boom years, everyone agrees, banks operated with too little equity and lent too much. At global regulators’ insistence, they are reversing that trend – which can they can do either by boosting capital or by shrinking lending.
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In complying with regulators, however, they risk riling politicians, who are desperate for banks – many of which benefited from government support during the crisis – to spur economic recovery in the “real economy” with more, not less, lending to households and businesses.
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But the truth is, their options are limited. Many lack sufficient capital to support increased lending, and cannot in any case finance it day-to-day in malfunctioning credit markets.
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Quite the reverse. The International Monetary Fund last month brought the message home to anyone who still believed the European economy – built on a glut of credit-funded borrowing and consumption for a decade and more running up to the crisis – could avoid a sharp correction. It warned that unless policy makers took preventive action, Europe’s banks would shrink their assets by €2tn in the next 18 months. “Synchronised and large-scale deleveraging” would, it said, be more severe than previously anticipated, posing a serious risk to economic growth.
The need to deleverage can be boiled down to this: the excessive lending of the boom years has come back to haunt the banks from every angle in the form of loan losses. Mortgage borrowers have been hit by property market collapses; corporate borrowers have been hit by slumping demand for their products. Even governments, whose debt the banks were encouraged to hold in the form of supposedly relatively safe sovereign bonds, look – in the eurozone periphery, at least – like shaky bets.
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“[Deleveraging] has to happen,” says Philippe Bodereau of Pimco, a leading bond fund manager. “Especially in markets like Spain, where there have been big asset bubbles. It’s just a question of how much you do from a policy point of view to soften the impact.”
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The European Central Bank, scared last November that commercial funding for lenders was evaporating as investors grew nervy about the eurozone periphery, launched an unprecedented attempt to “soften the impact” on banks and the customers that depend on them for credit. In a two-stage “longer-term refinancing operation”, the ECB injected €1tn of cheap three-year money into hundreds of Europe’s lenders.
Even with that cushion in place, regulators say deleveraging is not only inevitable, it is vital. “This process needs to happen,” says Andrea Enria, chairman of the European Banking Authority, which overseas the region’s bank supervision. “This is positive deleveraging.”
The EBA’s critics – especially vocal among the bankers and policy makers of the eurozone periphery – disagree. They argue that the EBA’s drive to impose higher capital ratios by next month has compounded the problems faced by banks and their customers, as have global regulators with their tough new Basel III rule book on capital and liquidity buffers.
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Bankers say the most sensible way to achieve higher capital ratios, given how expensive it is for them to raise fresh equity, is to reduce assets. “What you want to do in the current environment is shrink and lend less, not issue capital at a discount to lend more,” says one bank board member from the eurozone periphery.
It is a train of logic that infuriates regulators. “I do not believe that high levels of capital are a deterrent to new lending,” Mr Enria said in a speech in New York last month.
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“Banks with low capital levels – or perceived by the market as being so – are those that have had problems in increasing lending.
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Banks with large capital positions, by contrast, are less sensitive to cyclical shocks and more likely to pursue lending growth strategies.” He said the vast majority of the aggregate €78bn capital shortfall at the 28 banks that failed the EBA’s “stress tests” last year would be offset by capital raising measures. Only 1 per cent would be true cuts to lending.
Recent loan data from the Bank for International Settlements, which monitors global funding flows, suggests the European deleveraging process is well under way – whatever the role of new regulation.
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The BIS highlighted European banks’ continued retreat to their home markets in the last three months of 2011, with lending abroad showing a 7 per cent decline to $17.5tn, the sharpest fall since 2008 (though the slump is inflated by a 5 per cent appreciation in the dollar against the euro over the period). All banks shrank their overall eurozone exposure, too. Lending to eurozone companies declined 6 per cent, with shrinkage in Italy, Spain and Portugal, the countries hardest hit by the crisis, nudging 10 per cent.
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“We are seeing a net deterioration in lending to households across southern Europe, including France,” says Philip Suttle of the Institute of International Finance, which represents the biggest banks. He says European deleveraging is taking place in line with, or at a slightly faster pace than, what IIF researchers expected when they predicted last year that tougher global rules would force banks to shrink and charge more for lending.
Despite those trends, analysts agree that most of Europe’s bank deleveraging is taking place not through a contraction of new lending but through two other principal routes: the sale of subsidiary businesses and the sale of old loans – a process that many see as a natural evolution of global finance.
Huw van Steenis of Morgan Stanley in London warns that this could change if investors grow more nervous. “The more difficult the market gets in terms of asset sales, the bigger the plug that will have to be provided by less lending,” he says.
“The emphasis should be on disposing non-core assets outside Europe and, in some cases, the raising of capital,” says Mark Carney, the Canadian central banker who chairs the Financial Stability Board, a global regulator. He predicts that most banks will be able to shed unwanted businesses. “There is significant capital on the sidelines that will be interested in many of these assets at the right prices,” he says.
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Sure enough, as part of the tendency towards selling subsidiaries, European banks have divested self-contained units to rivals outside the region.
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Deutsche Bank is selling its asset management subsidiary to Guggenheim Partners, the US asset manager, to boost its capital. A similar shift to non-European buyers is evident in the sales of “legacy assets” – old portfolios banks might be prepared to sell at a loss in order to clean up their books. The purchase by Japan’s internationally ambitious Sumitomo Mitsui Financial of a giant portfolio of aircraft finance from a shrinking Royal Bank of Scotland – one of the biggest casualties of the crisis – is typical of the trend.
What seems certain, as the IMF prediction suggests, is that we are at the start of the deleveraging process. A glance at Europe’s top dozen banks shows, counterintuitively, that two-thirds have expanded their total asset bases in the past year. As capital and funding pressures intensify in the next year or two, that trend is bound to reverse, analysts say.
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Indeed, bleak as the IMF forecasts might sound to some, others say they are too benign. Deleveraging of €2tn amounts to only 7 per cent of European bank assets. “This scale of deleveraging doesn’t qualify as aggressive,” says Mr Bodereau. “It’s far less than we’ve already seen in the UK, the US, Ireland. The IMF is a reasonable base case, [but] you can easily paint a scenario where deleveraging gets much more painful in Europe.”
Furthermore, there is little evidence the ECB’s €1tn LTRO bank funding scheme is being channelled into the real economy, as some politicians might have hoped. Much of it has been used to buy sovereign debt – crucial for stretched governments in the eurozone periphery – or is sitting on deposit at the ECB. Many observers believe a third LTRO programme could be necessary, possibly in the next 12 months, both to give lending fresh impetus and to offset the impact of a €1tn “cliff edge” as cheap LTRO finance matures in 2014-15.
That said, the industry is adapting to the straitened environment for the region’s lenders. “Deleveraging by European banks has [cut] lending capacity [but] non-European bank lending and capital markets activity will help fill the gap,” says Daniel Pinto, head of JPMorgan in Europe.
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Underpinning that prediction is a shift in the way big European companies finance themselves. Some bankers have expressed concern about a slump in the three months to March in syndicated lending – big corporate loans spread around a number of banks. The slack appears to have been taken up by a boom in companies’ bond issuance, shifting the balance to the US model whereby three-quarters of corporate funding is bond-based and the rest bank-based, the inverse of the traditional picture in Europe.
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Still at risk, though, is the politically sensitive area of small company finance, where there appears to be both ailing demand and a lack of willing supply, given the relatively high risk and rising capital demands of lending to small businesses. Here, too, there are signs of innovation, with a number of private equity funds apparently eager to make up the gap in lending capacity by using the banks merely as distributors and risk assessors of the loans. It is too early to tell whether this model will work.
But the broader challenge in the next couple of years will be for banks and policy makers to strike a balance between undertaking necessary deleveraging and starving Europe – particularly its small-business backbone – of funding. If Ms Bonvicini is any guide, small businesspeople are not convinced the banks are up to the job.
“They revoke credit lines, expropriating companies, houses, assets which they then auction off at ridiculous prices,” she says. “If that weren’t enough, they apply very high interest rates. The cost to the small enterprise is prohibitive.”
Deleveraging: European groups hear echoes from the east
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Every financial crisis is different, but the pattern of bank shrinkage that follows a crisis – the “how much”, “where” and “what” – looks comparable across the globe and the decades, writes Patrick Jenkins.
In some ways the deleveraging story playing out today among Europe’s banks is shaping up as
a mirror image of what happened to Japan’s lenders amid its crisis 20 years ago.
Analysts at both Barclays and Morgan Stanley have highlighted that European banks are now following a similar deleveraging trend to Japanese banks in the early 1990s (and the broader range of Asian banks after their crisis later in the decade).
Europe’s banks today have an average “loan-to-deposit” ratio of 115 per cent, meaning that for every €115 a bank lends to its customers, only €100 is supported by deposits, with the rest financed in the volatile wholesale funding markets. With many banks aiming to be wholly deposit financed, with a 100 per cent ratio, the current trajectory of shrinkage suggests the deleveraging process has another three to four years to go – longer than the 18-month timeframe the International Monetary Fund’s recent analysis focused on. (Japan’s banks are now operating with ratios of less than 80 per cent compared with the same 130 per cent peak as their European peers.)
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The shrinkage at European banks is taking place on two fronts. As well as trying to sell off old asset portfolios, they are pulling back from ongoing business abroad.
There are two reasons for this. First, the eurozone crisis made it more difficult for banks to get dollar financing, not only key to doing business with US clients but also the global currency of trade.
Second, some of the activities are capital intensive and thus obvious targets as banks adjust to a tougher capital regulations.
Those pressures have led European banks to retreat from some historically strong positions. Some have squeezed their subsidiaries in eastern Europe and other emerging markets.
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However, one of the most marked trends has seen European lenders – particularly French – cede strong positions in global markets such as shipping and aircraft leasing, and trade finance.
With neat symmetry, some of the most aggressive groups to take on that business have been Japanese. Asian trade finance is now dominated by Japanese banks, with a market share of more than 50 per cent, according to Morgan Stanley, up from 6 per cent in 2010, while the share of eurozone banks has shrunk from more than 40 per cent to just 3 per cent.
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Copyright The Financial Times Limited 2012
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