April 19, 2012 / 6:46 PM / 7 years ago

No avoiding credit squeeze as Europe's banks shrink

LONDON (Reuters) - Europe’s banks are aggravating the region’s economic woes by rapidly adopting tough new rules for capital, raising the risk they will have no money left to lend to companies and support economic recovery.

Bloated with risky loans and bad debts, banks are slashing their assets, but this has so far failed to convince investors, hurting the banks’ ability to source the capital they need to lend to credit-starved customers.

“The genie is out of the bottle. Banks are hellbent on shrinking balance sheets so that they can then start to focus on running their businesses rather than spending time dealing with regulatory matters,” said Chris Wheeler, analyst at Mediobanca.

The unintended consequences of the regulatory clampdown were flagged this week by the International Monetary Fund, which warned that deleveraging will squeeze credit availability in the euro area by 1.7 percent over the next two years.

If economic conditions worsen, credit availability could contract by a further 4.4 percent, the IMF said.

Italy, Spain and other weak economies in the euro zone - already grappling with slowdowns and huge budget deficits - will be hit hardest, while companies in stronger countries like Germany enjoy a surplus of willing lenders.

Stringent new capital rules known as Basel III to be phased in from next year are hitting banks even harder than many in the industry had first feared.

Lenders across the region have curbed new lending to focus on offloading toxic or non-core assets - reducing the denominator of the capital over assets ratio - in the hope of maintaining the confidence of fickle capital markets.

But the banks still have to reduce assets by 30 percent if they cannot raise new capital - or a staggering 13 trillion euros (10.63 trillion pounds) - according to Ruediger Filbry, head of banking practice in Germany at Boston Consulting.

Most analysts predict a more modest, but still painful, reduction of assets - a process known as deleveraging - of around 3 trillion euros of loans, or 5 to 7 percent of assets.

Adding to their woes, Europe’s banks don’t have time on their side. By June, the European Banking Authority has demanded that they boost their capital by 115 billion euros.

“(Regulators) are asking banks to do contradictory things. They are asking them to reduce their assets, rebuild capital and increase lending all at the same time. It’s just an impossible cocktail,” said John McNeill, investment manager at Kames Capital.

“The combination of Basel-type regulation, with that of domestic regulation, has exacerbated the credit crunch.”

SOURCING CAPITAL

Part of the problem is that Europe is far more reliant on banks for credit than the United States, where borrowers issue bonds directly or use “non-bank” intermediaries.

European companies are looking for other sources of debt financing beyond bank loans, and have started tapping the corporate bond market, but it is a slow process.

“Credit can be channelled through other means than banks, but it takes time to establish a system through capital markets,” said Niels Thygesen, an emeritus economics professor at the University of Copenhagen, who served on the Delors commission which created the euro.

In Europe banks provide more than two-thirds of credit, whereas in the US the proportion is less than one-third.

The IMF and the EBA have said they would prefer banks to raise fresh capital to recapitalise. But that’s unlikely in the current environment, with sluggish returns for investors offering no incentive.

Italy’s Unicredit (CRDI.MI) raised 7.5 billion euros in a rights issue in January, but the process was rocky and the appetite of investors is limited.

Basel III requires banks to have a minimum core capital ratio of 7 percent of risk-weighted assets. This benchmark will be phased in from 2013, with full implementation due in 2019.

The Basel Committee of global regulators last week said if Basel III had been in force at the middle of last year, banks would have needed an extra 486 billion euros to comply.

About half of that would have been in Europe.

Banks have an average core capital level of 10.2 percent at the moment, the Bank of International Settlements said. Under Basel III rules, the number would be a far less impressive 7.1 percent.

Another problem is that the assets the banks are managing to off-load are typically the higher-quality ones. That leaves them stuck with more troubled assets that they need to sort out later, potentially increasing the “tail risk” of the crisis.

“What is good and rational for the few may be disastrous for the many - deleveraging an over-extended institution or country works when there are those able to take up the slack but doesn’t if everyone does it at once,” Douglas Flint, Chairman of HSBC (HSBA.L) told a conference this week.

Additional reporting by Sinead Cruise and Sarah White in London, and Arno Schuetze and Alexander Huebner in Frankfurt; Editing by Hugh Lawson

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