Europe's BROWNIANOMICS

If recession is to be addressed in the USA by Obamanomics, across the pond in Old Europe it's Brownianomics. Europe’s banks need additional €83bn ($105bn) capital injection (if downturn matches the early ‘90s, according to Morgan Stanley). This appears conservative to me. In the UK alone banks’ write-off are expected to reach $480bn (£290,€360bn) over the next 3 years, which demands at least a 2.4% deficit spending boost to the economy in 2009.
The forecasts underscore how European banks, which have already raised €117bn to strengthen balance sheets in 2008 (which means replenishing capital reserves shredded by mark-to maket losses and share price falls). Once restored, this capital is vulnerable next to corporate loans defaults, consumer debt and commercial mortgages. On top of this the banks need extra capital to provide a positive net flow of credit to the economy. Even though European governments have upped direct support to banks, the bail-outs have not restored the flow of credit to the rest of the economy. The ECB (pictured) have not yet abandoned the idea that interest rate cuts should be cautious in view of monetary inflation risks, while France and probably UK, Spain and Italy are likely to break the Maastricht deficit and debt ratios on which the Euro was founded.
Morgan Stanley analysts argue, in aggregate, that loan books of Europe’s publicly traded banks need to grow just 1% in 2009 (i.e. lending for consumers & companies will be scarce and expensive). This is well below the rate of inflation. Growth in bank lending needs to be 2.5% minimum to have a neutral but not negative growth impact.
Without recovery in the capital markets, banks’ restraints on new lending will make the economic downturn more severe and longer lasting. The cost of capital for banks increased sharply since the start of the crisis, squeezing future returns,; cost of equity for banks rose about 12.5%, while future returns – only after the crisis has receded – are likely to be no more than 13%. Credit Suisse predicts UK banks cannot generate returns “significantly above” the cost of equity “in the medium term”. Banks’ are deleveraging to get assets back in line with deposits. Success in this and profitability depends on being able to resume packaging loans and selling them to investors in the form of securitisations or borrowing from interbank money markets to fund balance sheets. Securitisation is discredited and the products illiquid and interbank funding is only flowing relatively freely via the central banks discount windows. Hence, banks are largely unable to fund themselves in the wholesale markets without government support. Share issues are dangerously diluting. Another option would be bank bonds if necessary backed by government guarantee. In Europe, there was about €3tn ‘excess loan formation’ over deposit formation in 2002-07. This is being rolled over (worked out) with the help of a government guarantees. Additionally, loan losses (non-mortgage) may grow to about €1tn gross, €0.5tn net. Furthermore, regulators want another €0.5tn in higher capital reserve buffers (Basel II, Pillar II). In the UK, where Government is pressing backs to restore lending to 2007 levels, the FSA is requiring the largest banks to raise additional capital to shift from regulatory reserves (Tier 1, Basel II Pillar I) from typically 4-6.5% to 8% plus another 3.5% buffer.
Assuming an 8% regulatory capital of say £200bn and banks currently at 5%, then they need to raise £162.5bn or reduce assets (deleveraging) by £4tn (equating to the total assets of 3 big clearing banks!). The result will be a combination of both capital raising and deleveraging (much of it by selling off non-core subsidiaries and foreign-based banking units), plus a very likely failure to attain the FSA’s required capital reserve ratios. In the event of a severe downturn, the MS and CS and other analysts estimate that HSBC, for example, would have to raise $27bn of fresh capital to maintain core tier one capital – a measure that excludes debt-like instruments – at no less than 7.5% of risk-weighted assets. Deutsche Bank would need to raise €8.4bn, while Santander would need €6.6bn.