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The banks’ real stress test is still to come

The solvency of Europe’s governments has been under the spotlight in recent months, but Europe’s fragile and under-reformed banking system is a disaster waiting to happen, says Hugo Radice

April 15, 2012
7 min read

In the ongoing euro-crisis, political leaders are constantly criticised for not being ‘ahead of the curve’, flummoxed by the speed at which market sentiment changes. But following the turmoil in sovereign bond markets and the political deadlock in the European Union, the biggest problem of 2012 may be a new banking crisis. It is becoming increasingly clear that banks across Europe face a serious funding problem in the coming year, a problem that goes to the heart of what is wrong with the current culture and practices of the financial sector.

As has been much discussed in recent months, European banks could incur huge losses if further ‘haircuts’ are imposed on their holdings of eurozone government debt, while the stalled recovery – dragged down by ill-judged austerity policies – threatens to expose them to higher losses on their loan books. But far more threatening over the next year or so is the question of how they can sustain their own finances.

A bank draws its funds from four main sources: share issues, deposits, loans and retained profits. As in any capitalist enterprise, shareholders provide the risk capital for use in speculative activity. Depositors seeking a safe and convenient place to store their money traditionally provide the bulk of the funds, which the bank then lends while holding a modest proportion in reserve to meet any withdrawals by depositors. Banks borrow additional funds from the money markets, where lenders buy securities issued in the form of term deposits or bonds.

Although these four sources are in principle distinct, in practice they are all governed by risk and return expectations derived from the same sources of information – the bank’s accounts, credit ratings agencies, the media and the market rumour mill. A bank whose prospects are judged good will be able to draw on all four sources.

Easy and cheap

In the run-up to the 2007–8 banking crisis, banks expanded their activities very rapidly. At the height of the boom, borrowing was easy and cheap, so banks such as RBS and Lehman Brothers not only increased their debt levels massively in relation to their equity capital and reserves, but they also kept down the cost by borrowing for relatively short periods of one to five years. They believed that they would have no difficulty in ‘rolling over’ these debts when they fell due – or even that they could redeem them with cash from depositors, shareholders or retained profits.

What happened instead was that, like all credit booms, this one ended in a crash. Beginning in the sub-prime household mortgage sector in the US, rising default rates brought to light the fantasy world of ‘no-risk’ finance. The widespread use of derivatives, developed on the basis of models that bore little or no relation to the actual functioning of financial markets, had meanwhile created chains of potential contagion that reached to the furthest corners of global finance.

As investors began to appreciate the real risk to the market value of their financial assets, there ensued a classic flight to cash. As a consequence the wholesale money markets, in which banks borrow from each other and from other investors, began to freeze up. Bank debts falling due could not be rolled over any more, so the main source of discretionary funding for banks disappeared. As so often Britain led the way, with the collapse of Northern Rock in September 2007, and the slide into the global banking crisis began.

In 2008–9 central banks and governments succeeded in stabilising the banking systems in most countries through massive infusions of funds in the form of equity (as in the UK government stakes in RBS and Lloyds), loans from central banks or cash from central bank purchases of financial assets held by banks (notably through ‘quantitative easing’). But banks still held huge amounts of outstanding debt that would contractually fall due in the next few years.

Already in November 2008, the Crosby Report highlighted the difficulties facing UK mortgage lenders as a result of the freezing of global credit markets: if they were unable to refinance their borrowing, how could the flow of mortgages and thus house prices be maintained? The banks have muddled through since then, helped by the continued very low level of activity in the UK housing and mortgage markets. But the continuing overhang from the boom makes them acutely vulnerable if market pessimism and uncertainty leads to a new freezing-up of credit markets.

Evidence of this looming problem has been mounting since the middle of 2011 across Europe. In June the Bank of England reported that ‘major UK banks still have up to £300 billion of term funding . . . due to mature before the end of 2012’. In September Deutsche Bank analysts estimated that European financial institutions needed to refinance nearly €2,000 billion over the next five-year horizon, while in November Lloyds Bank had nearly £300 billion of wholesale funding outstanding, half of which matures in 2012. Credit default swaps, which are used to insure against loan defaults, have become even more expensive than when Lehman Brothers collapsed.

The banks also face other problems. Since 2008, central banks, national governments and the European Commission have all been insisting that banks increase their reserves to levels that would guarantee their survival in the event of a new financial crisis. Although the Bank for International Settlements has still not secured full agreement on the so-called Basel III rules, monetary authorities have imposed interim measures requiring banks to raise substantial new capital.

On top of this, the banks face substantial cuts in their investment banking income as a result of the stalled recovery. Meanwhile, in the UK especially, there is constant pressure from politicians and industry for banks to increase their retail lending to businesses, especially given the failure of Project Merlin, the agreement to support small and medium-scale enterprises announced by the coalition and the banks with much fanfare in early 2011. Not surprisingly, in the face of all these threats the ratings agencies have not hesitated to downgrade the credit ratings of most European banks, as Moody’s did in the case of 12 British lenders in early October.

Looming crisis

In recent months central banks have taken steps to head off the looming crisis. They have all provided more money to their banking systems, either through the purchase of financial assets or simply by lending them money at very low interest rates. At the end of November the major central banks also announced that they would fully support each other in supplying funds to meet any new crisis in the money markets. This seems to have been triggered by the flight of money out of the eurozone.

In late December the much-criticised European Central Bank offered unlimited three-year loans to eurozone banks, which promptly borrowed nearly €500 billion. Eurozone finance ministers might have hoped that some of this money would be used to purchase government bonds, or at least to encourage a revival in the inter-bank market. But such is the current climate of chronic uncertainty that the banks’ short-term deposits with the ECB rose to over €400 billion.

Given the glacial pace of regulatory reforms, banks now face much more urgent pressures as the world economy threatens a return to recession. The European Banking Authority’s much‑derided ‘stress tests’ announced in July 2011 found that only eight out of 90 banks failed to meet the standard set for their required levels of capital. But in the coming year, a flat‑lining economy and continued turmoil in financial markets will provide a much more severe test.

Although it is likely that any major bank collapse would again be contained by a state bail-out, as in 2008, the failure of governments to achieve effective reform is a major indictment of current institutions and policies. It is up to us to develop real alternatives that will not only rein in the rogues, but also re‑establish banking systems that will meet the day-to-day needs of households and businesses alike.

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