Is the Eurobankster “We’ll Shrink Our Balance Sheets” Threat Largely Empty?

Yves Smith

Even though the Greek move to blow up the latest Eurorescue plan caught the world’s attention, another pushback is underway, this via the blue chip lobbying group, The International Institute for Finance.
The threat, which has surfaced before and is picked up in an article by Bloomberg, is that raising capital levels as mandated under the latest version of the Eurorescue plan, won’t take place by selling equity, retaining earnings (which would almost certainly mean constraining pay levels) or accepting government equity injections (which will come with nasty strings attached). Instead, banks will just shrink to meet the targets by selling risky assets. (Note that the targets, which are being met with howls by the industry, are for them to write down sovereign and reach a core capital level of 9% by June 30, 2012).
This is meant to be a threat. “Shrinking assets” implies less lending. Less lending would put a downward pressure on economic growth. Recessionary or near recession conditions tend to lead voters to throw elected officials out. So this sabre rattling is clearly meant to get the officialdom back in line.
How seriously should we take this?
First, it’s likely that the June 30 timeframe would severely constrain the ability of banks to execute on this threat. Who exactly is going to buy these assets? Other, similarly situated banks won’t, at least not in sufficient size. Banks in most other advanced economies are also subject to “increase equity level” requirements, even if not as severe as those faced by the Eurobanks. Hedgies might, but we have an open question as to whether banks will be tightening terms on their prime brokerage lending (Deutsche Bank is one of the top four prime brokers). And even if they took some assets, they lack the capacity to take anywhere near enough. The Eurobanks’ total assets are 325% of GDP. Even changes at the margin add up to big numbers quickly.
Now the general rule of finance is everything can be solved by price, that if you lower prices enough, demand rises considerably. But the big banks are loss constrained. If they have to show much in the way of losses on the risky assets they are threatening to dump, the net effect would be to lower rather than increase equity to total asset ratios. And that’s before we get to the all-too-likely possibility that some of these assets are held at unrealistically high valuations. So that means you don’t even need market selling pressure to reveal losses; trying to unload some of these holding in a “normal” market would expose what Geithner called “air in the marks”. Remember, regulatory forbearance, otherwise known as extend and pretend, has been the name of the game.
Second, the banks really really don’t want to shrink either. Bank CEO pay is highly correlated with the asset size of the institution. And the risky assets they are threatening to dump are big profit drivers in good times, so getting rid of those would have an even bigger impact on reported bank profit and hence compensation of the top brass.
Third, with the Eurozone economy in low growth/near recession conditions, it isn’t clear that bank capacity is constraining lending. Businessmen don’t like to borrow for the fun of it, they do so to pursue profit opportunities. Unless a business is countercyclical or in a niche that is doing well, they don’t have strong reasons to be borrowing right now. And in the countries where housing bubbles were a big part of the debt explosion, mortgage debt is going to shrink over time.
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Finally, cutting the banks down to size is necessary to end their looting. Gene Frieda argued (in economist code) that the Eurobanks’ business model was unsustainable in its current form and the banks needed to shrink by 50%. From his article:

Higher levels of capital are required for two main reasons. First, economic growth looks set to be much weaker than expected, meaning that capital buffers will need to be built. The European Banking Authority’s stress-test scenario from June looks more like the baseline scenario today. If traditional asset-quality considerations were the only problem buffeting eurozone banks, recapitalization would restore investor confidence, debt markets would reopen, and banks would find raising capital much cheaper than it is now. That isn’t happening, because the problem is growth.
Second, with the demise of sovereign-debt equality, eurozone banks will require higher capital-adequacy ratios to compensate for higher risk. Banks in emerging markets tend to carry higher capital buffers for a similar reason. Just as business and credit cycles there tend to be more frequent and extreme, the real possibility of de facto currency crises in the eurozone, owing to higher sovereign borrowing costs and slow adjustment to shocks under fixed exchange rates, renders massive balance sheets unsupportable and thus obsolete. Higher capital ratios are required today and, absent a credible sovereign safety net, in the future.

Thus the outcome that the IIF depicts as peril, that of making megabanks much smaller, is precisely where they need to go. The issue that should be argued isn’t whether or not the European banking system needs to shrink. It does. The question is how much and how quickly. The failure to put this issue front and center in policy formulation is likely to lead to inconsistent responses which may well play into the banksters’ hands.