Euro banks opt to cut lending rather than raise capital--that can't be good for growth

11/01/2011 1:10 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

So much for the grand plan to buttress the strength of European banks by requiring them to raise $150 billion in additional capital.

In the days since the European Banking Authority announced that goal and spelled out which banks would need to raise how much, Europe’s banks have pushed back with their own plans to meet the new 9% capital ratio.

And to no one’s real surprise, the banks are opting to sell assets and shrink loan portfolios rather than try to raise capital in financial markets that have marked European bank stocks down, in many cases, below their book value. And banks look like they will do everything possible to avoid having to take government funds that would give politicians a say on dividend and bonus payments.

The latest estimate from Morgan Stanley is that of Europe’s 28 biggest lenders only eight will raise capital. And that the total additional capital raised will add up to just $15 billion instead of the $150 billion figure from the European Banking Authority.

I can see two effects of the banks’ decision—both negative.

First, selling down assets and reducing loan portfolios will indeed enable banks to reach the 9% regulatory capital requirement. But it won’t do much to make these banks better able to withstand future shocks to the European financial system. (Especially because it’s likely that the assets that banks will be able to sell at what they regard as reasonable price will be better rather than worse quality assets in many cases.) And increasing capital ratios this way won’t do anything to fix the over-reliance of European banks, especially French banks, on the wholesale capital markets for operating funds. They will still be extremely vulnerable to any shutdown of the money market funding market, for example. (But then the European Banking Authority plan wouldn’t have fixed this problem either.)

Second, reducing loan books means making fewer loans means slowing growth in European economies even further.  The EuroZone was already at risk of a recession. The decision to reduce lending makes that risk higher. Before the grand plan announced last week banks had warned that they would cut lending if they were hit with higher capital requirements. It looks like most will make good on that threat.

A recession, of course, would make it even harder for countries such as Greece, Portugal, Spain, Italy, and France to reduce their budget deficits to the degree that governments have planned. And slower growth means that to reach those targets governments will have to cut budgets even more deeply. Which presents another drag on growth.

The intentions in requiring banks to raise additional capital were good—the goal was to strengthen the European banking system. But good intentions are no longer enough, if they ever were, in this banking crisis.

 

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