Will European banks destroy the world?

According to the IMF’s latest Global Financial Stability Report (GFSR), one of the most pressing threats facing the global economy and the international financial system is the possibility of massive, synchronised deleveraging at European banks. Such deleveraging, which could, in the worst case scenario, run to the tune of $3.8tn (about 10% of European banking assets) if policymakers mess things up, could shave around 1.4% off GDP growth in the euro-zone by the end of next year, which would have terrible consequences for global growth, and for South African growth in particular, as SA’s economic fate is strongly tied to what happens in Europe. Given SA’s tepid growth, this is an ominous prospect. Let’s take a look at the problem, and what the IMF says policymakers should do about it.

The deleveraging drama

Since the sub-prime crisis back in 2007/8, banks in rich countries have been under pressure to deleverage - which basically means increasing the buffer of capital they hold versus money they've lent out by getting rid of all the junk on their balance sheets, either through selling off unprofitable assets, writing-down the value of bad loans, reducing the amount they lend, or any other means that come to mind. This has generally been a good thing, since most Western banks entered the sub-prime crisis in an undercapitalised state.

However, European banks were more highly leveraged and slower to deleverage than their American peers, as the chart below (taken from Chapter Two of the IMF's April GFSR) illustrates. The result has been that as various problems have emerged, European banks have taken a serious pounding.

The troubles began in 2011, when Europe began to experience a wrenching fiscal crisis in which country after country faced serious budget shortfalls and skyrocketing interest rates on their sovereign debt. This was very bad for European banks; their stock prices came under enormous pressure as investors began to worry about their large European sovereign debt holdings and relatively high levels of leverage. What's more, with yields on government debt high and with sovereign debt flooding the markets, funding sources for banks - especially short-term funding - began to dry up.

Compounding the problem, depositors, worried about potential bank collapses, began to withdraw their money from banks domiciled in Spain, Italy, Greece, and Ireland (the countries worst-hit by the debt crisis), further shrinking the funding pool. Fearing a melt-down, the European Central Bank (ECB) stepped in with a number of palliatives, in particular increasing its lending to banks in the form of unlimited collateralised loans for up to three years. This eased the immediate problems, but according to the IMF, if further action is not taken, banks will reduce their balance sheets by some $2.6tn between the end of September this year and the end of December in 2013. This would represent a 7% contraction in European bank balance sheets, and would, according to the IMF, result in a 1.7% reduction in the supply of credit in Europe (since part of the shrinking would involve lending less).

In what the IMF calls the "weak policy" scenario, if European institutions are too slow to implement current policies or there are any external shocks, bank balance sheets would contract by $3.8tn (10%), leading to a reduction in the supply of credit of about 4.4%.

However, all is not lost. The IMF says that, under a "complete policy" scenario, bank asset shrinkage could be reduced to $2.2tn, which would reduce credit by just 0.6% and would boost GDP growth in the euro-zone by 0.6%. In order to achieve this happy outcome and avert disaster, the IMF says that European policymakers would need to unleash a fuller arsenal of weapons. First, they would need to implement sensible fiscal consolidation programmes that would balance austerity and growth promotion - many of the current plans for Europe's troubled sovereigns involve deep cuts that will probably hamper growth.

Second, they should focus on restructuring troubled banks, including making it possible for the emergency funds that the region has established to inject capital directly into troubled banks. Finally, Europe should pursue structural reforms in a bid to make the monetary union more stable, sustainable, and integrated.

This is a pretty tall order, given the chaotic and at times ineffectual responses that European policymakers have so far produced. However, the threat of a potential credit crunch, which the IMF says could ravage corporations in the region as well as dragging down growth, may help focus minds on generating real solutions. For the sake of the world economy, let's hope so.

By Felicity Dunham

This article was published on www.moneyweb.co.za