Wednesday, March 28, 2012

Weaknesses in the European Banking System

The Wall Street Journal worries about the future of European banks (h/t Tyler Cowen). Unlike US banks, the WSJ points out, the Euro banks provide most of the funds for mortgage and corporate financing. In the US, these functions are shifted, respectively, to the "government-sponsored entities" FMAC/GNMA and to the corporate bond market. Consequently, US banks have much lower loan-to-deposit ratios than European banks. The different balance sheet structures leave European banks vulnerable to sudden shifts in money-market sentiment:
The question for European policy makers is whether the European banking model is now permanently broken as a result of the crisis—as the U.S. banking model was broken by the crises of the 1930s and 1980s. Or is the current refusal of markets to fund parts of the European banking system a temporary phenomenon that will pass once the sovereign debt crisis eases? There's some reason to hope the latter: While there is little correlation between bank capital ratios and funding costs, there is a strong correlation between the cost of bank funding and government funding. For example, BBVA, one of the best capitalized banks in Europe, must pay far more for bond market financing than Deutsche Bank, one of the euro zone's most thinly capitalized banks.
But what if funding markets don't recover? The ECB's Long-Term Refinancing Operations bought time, providing banks with cheap three-year loans to replace lost bond market financing. But if time doesn't prove a great healer, the euro zone will face unpalatable choices. It could try to create a U.S.-style system, reducing high bank LDRs by encouraging far greater use of capital markets. But this may require the creation of euro Fannie and Freddie, surely a political non-starter. Or it could brace itself for a repeat of Japan's experience with banks continuing to deleverage until LDRs reach U.S. levels—a process that could take six years and would require them to shed up to €4.5 trillion of assets, reckons Morgan Stanley. Or the ECB could continue to fund the shortfall with yet more LTROs. But that would mean the European banking system remaining in intensive care for years—and doubts over the health of the economy never fully going away.

See also this FT article.

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