Article / 28 October 2016 at 10:00 GMT

Europe's banks need bullying by Basel

Managing Partner / Spotlight Group
United Kingdom
  • European banks have a high risk density and inadequate capital reserves
  • Basel Committee wants greater provisions set aside to insulate risk assets
  • This has been met with resistance by European banks and governments
  • If another systemic financial crisis is to be avoided, the regulator must stand firm
Basel, Switzerland
 Basel, Switzerland, hometown of banking regulation. Photo: iStock

By Stephen Pope

Many problems dog the Eurozone. GDP growth is soft at 0.3%, and regional unemployment is running at 10.1% for all workers and rather depressingly at 20.7% for young people between 18 and 25 years old. No wonder European youth are described as “the best educated but least hopeful generation”.

The Eurozone/European Union is a free-market-based economic system with varying levels of economic efficiency and bureaucratic interference across all its member states. However, for a modern market-based economy to flourish it requires a lively and fully functioning banking system to ensure the smooth and timely transmission of capital to the institutions and individuals that need it.

In need of repair and restoration

Europe urgently needs to correct a banking system where loans to households in the Eurozone increased by merely 1.8% year-on-year in August, unchanged from the pace in the previous two months. This is still off the pace of 1.84% seen in August 2011. Overall loans to the private sector were booked at EUR 10.6 trillion in August and have almost flatlined since late 2008.

Clearly there's a problem within the banking system, and that is acting as a deadweight or fetter on the regional economy. Despite massive waves of monetary accommodation from the European Central Bank (ECB) and statements from governments determined to fix things, the problems affecting Eurozone/European Union banking are not being taken seriously.

Sub-par performance

Looking at a snapshot of four leading European banking giants, I see horrendous losses in their share price performance: in the year to close of business on Wednesday, October 26, 
Société Générale's stock was down 15.68%, UBS down 29.87%, Commerzbank down 35.09%, and Deutsche Bank down 40.95%.

The slide in European bank share prices appears to be directly linked to a decline in earnings expectations. The continual revision downwards of earnings mirrors the impact of the aggressive monetary accommodation that has brought low revenues from lending coupled with ever-higher capital requirements.

The drop in the share prices of the two German titans can spread across the sector like ink on blotting paper and potentially leak out into the wider economy. In short, if a formerly great bank hits hard times in a short period, it can have an impact of systemic significance.

Deutsche Bank
 Deutsche Bank trading room. Problems affecting the German heavyweights can have 
systemic implications. Photo: Deutsche Bank

Seeking solvency

Some reports have dismissed the potential of solvency problems across the continent, but I think that is a rather naïve view.

In the summer, the European Banking Authority (EBA) issued a report on asset quality in the EU banking sector. The analysis, based on supervisory data on non-performing loans (NPLs) and forbearance (FBL) for over 160 EU banks, revealed that despite improvements NPLs remain high, with serious implications for the banking sector's profitability and regional economic performance.

With an average ratio at 5.7%, NPLs in the EU remain up to three times higher than corresponding levels in other global jurisdictions.

The report identified various structural impediments, including legal systems, the unrealistic duration of court proceedings and the variation of and complexity within EU member tax regimes.

Another critical problem is the burden of capital provision and regulation that has fostered the absence of a deep and liquid secondary market in NPLs.

Capital requirements and a market in NPLs

The critical issue is the standard for capital adequacy that can allow a bank to accommodate losses without suffering a severe balance-sheet shock or even itself going into liquidation.
It cannot be denied that sub-standard levels of capital adequacy in 2008 tipped single-entity difficulties into a full-scale crisis.

Regulators were right to force banks to adhere to a more rigorous capital standard in 2010. However, the progression of this has seen the Basel Committee on Banking Supervision, i.e. the global regulators around the world, firm up the rules that tell banks how to comply.

But one of the most troubling aspects about regulating capital is achieving a genuine and reliable measure of risk. The riskier a bank’s investments, the more capital it needs to set aside.

Of course, the banks frequently disagree with the regulators on how to judge the degree of danger, and all too often different banks deliver widely different interpretations of the risk profile when evaluating a specific basket of assets, and so how much capital needs to be set aside.
Bank Capital Source: Investment bank reports and International Monetary Fund

Asian banks, in general, have higher capital adequacy ratios than banks in the US. However, American institutions are better capitalised than their European peers. (As a side note, the low levels of capital held by Chinese banks may spell future problems, though that is beyond the scope of this essay).

The Basel Committee, has noticed this fact and is targeting capital improvements at those banks whose models generate the lowest-risk weightings and thereby create most benefits in reducing their capital requirements.

As one might expect, the banks tend to shoot for a lower level of capital provision than the regulators. Banks appear prone to underestimate risk to contain the cost of capital provisions. That means they have low capital ratios and, as such, have less equity to cover any demands to increase capital.

Less latitude

Regulators therefore want to give banks less latitude to make such capital adequacy judgments.

This will disproportionately affect European banks versus American peers as the Europeans have designed their risk-modelling to seek the minimum possible capital to be set aside. In contrast, US banks have continued to follow a simpler system of leverage ratios that use plain asset measures.

This is quite a stark contrast to the dark days of the US financial system when Bear Sterns and Lehman Brothers failed and AIG was only saved by federal support.

This is where the Basel Committee has to enforce the rules through an aggressive approach as against relying on self-governance. So strict bounds have been proposed for the risk weights that banks can apply to their assets along with plans to introduce a universal process for calculating operational risk. These restrictions are planned to be in place by the end of the year.

 Frankfurt. Politicians insist that regulations must not be disproportionately 
harsh on Europe's banks. Photo: iStock 

Government and bank dismay

The proposition has not been well received at a national government level, or indeed in the boardrooms of Europe’s major banks.

German finance minister Wolfgang Schäuble has said that the rules must not affect the region’s banks disproportionately. He is clearly mindful of the pressure that has surrounded both Deutsche Bank and Commerzbank.

Other politicians have suggested that EU banks should simply ignore the Basel process for cooperating on financial regulation.

Isn’t this just another example of the EU proving that most nations will always retreat into a shell of self-interest instead of agreeing to a policy that is beneficial in the long run for all of Europe?
For their part, bank executives have suggested that such changes are being introduced at the very time when the industry is struggling to record any profit.

This smacks of petulance as Europe’s banks lived too high a lifestyle for many years and were too eager to chase after all and any market-orientated opportunity to build universal banks that could compete in the global capital markets. So refusing to comply will only further mark out those banks that are too cavalier, and their share prices will continue to suffer.

More money needed now

At the end of the day, it does not matter how the European banks choose to evaluate their risk assets, because the truth is they all require more capital. The practice of the past where losses were shuffled around to different books from one quarter to another, or disguised, is nothing less than a failure to recognise losses.

This has now left too many European banks with too many bad loans. The new demands of capital adequacy mean that the banks have insufficient capital to invest in growth.

For all the hard luck stories, the powers that be in Basel should not backtrack. They should demand that all banks that wish to hold risk assets protect their depositors first and foremost by seeking a higher minimum requirement for capital as a percentage of the risk assets.

With ever smarter technology, there is no reason why the banks cannot have a direct feed of risk and reserve balances sent in real time to the regulator so that any bank's leverage can be calculated and plut under scrutiny by a Basel stress test.

It is time for Europe to bring its lazy, mollycoddled banks into the harsh reality of the light. 

— Edited by John Acher

Stephen Pope is managing partner at Spotlight Ideas

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