Chasing tail: Europe risks cutting cash

With the Eurozone chasing its own tail, it is vital that it doesn’t continue the very liquidity issues that everyone is trying to resolve.

Yes, you really have let it get that bad.
Simon Miller
On 14 October 2011 11:29

Whatever your views on quantitative easing – and boy it is a debate that will be going to go on for quite a while – the one thing that most people do agree on is that there is a liquidity problem.

Simply put, there isn’t enough cash around. 

As I mentioned last week and John Phelan  has so ably demonstrated, when money is released it never seems to get where it’s needed – the public and businesses in the form of lending and credit. 

And this isn’t a case of those greedy bankers. They need the cash as much as you and I.

The capital ratio requirements mean they have to build a buffer to withstand the tremors in the system. So when cash is released, you can generally bet that it doesn’t go further than the main account.

And capital ratio issues are not restricted to the UK. This week EC president Jose Manuel Barroso launched his action plan to save the Eurozone. He admitted that the rest of the globe looks at events in Europe in despair and promised to "break the vicious circle between doubts over the sustainability of sovereign debt, the stability of the banking system and the European Union's growth prospects" before the G20-imposed November deadline. 

To this end he said that there would be compulsory demands for higher capital ratios. Now I like capital ratios; if you are going to lend the money, make sure you have the cash to back it up in case of default. The only bailing out should be done privately and not by the taxpayer. 

But, and there is always a but, if you have to raise capital, you really should make sure the timing’s right.

In the UK, the Independent Commission on Banking has given a very generous timescale of 2019 for implementation of its ten percent minimum requirement. In addition, capital markets still appear to be open to UK banks.

But even that generous timescale has slowed lending down, no matter what champions of Project Merlin claim. And in Europe the situation is about to become worse.

With global exasperation reaching an apex and a November deadline for Europe to actually do something to assure the world, it is obvious that action was needed but the capital ratio proposal couldn’t come at a worse time.

What the EC proposes is to basically introduce, and surpass, the Basel III requirements to Eurozone banks early. Instead of a seven percent ratio, the money’s on them introducing a nine percent ratio.

In normal circumstances, banks go to market to raise capital but these are not normal circumstances. With European banks trading at around sixty percent of their book value, capital-raising ends up being a costly exercise. And that’s if banks could get hold of any money anyway.

Investors take one look at the sovereign debt exposures and credit ratings abound and say “no thanks, I’m going to gold”. 

So what do banks do, or to be precise, what do they seem to be doing?

As Harold Macmillan once famously said of Margaret Thatcher, they are selling the family silver. With assets being the denominator of capital ratios, and the markets essentially closed off to them, banks are trying to reach the targets through stripping back.

French banks BNP Paribas and Soc-Gen are already looking at a combined €110bn (£96.2bn) sell-off of assets to shrink themselves under the target ratio levels and cut their dollar funding needs. 

And where they go, other European banks will surely follow. As a result, and in a lending market that is already stagnating, this contraction of banks could result in even less money being available to lend, hence restricting growth once again. 

And without growth, deposits slow down and banks lose even more money – Europe is definitely in a dog chasing tail scenario, running in circles in an apparently useless objective. 

The problem is that for three years Eurozone leaders have abjectly failed to confront the situation in front of them and have used a plaster when perhaps a full amputation was needed. 

Be it letting banks go, or letting Greece fall, or creating full union and all that entails, a definitive statement of intent was needed six months ago, hell even a year ago. By hedging, fudging and prevaricating Eurozone leaders have created the very conditions that they were desperate to avoid. 

With the G20 ready to twist some arms and bash heads, action is finally being taken, but as we see, the timing could not be at a worse in terms of raising capital and adding liquidity to the system. 

The good news is that dogs sometimes do catch their tails.

The bad news is that when they do, they don’t know what to do afterwards, standing there in utter confusion and wondering where the pain is coming from. 

And I very much fear that this dodgy (or should that be doggy?) metaphor very much applies to the Eurozone. What will happen when it catches its tail? How much pain will occur and will it know where it comes from?

Simon Miller is the Editor of Financial Risks Today. He tweets at @simontm71 

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