Reuters Columnist James Saft on Europe’s Credit Crunch; Bank Capital

By | May 2, 2012

Europe looks to be entering a credit crunch, with loans harder to get and those that are made coming on tougher terms.

Strikingly, banks are being tight despite falling demand for credit, pointing to a nasty interaction between the economy, its banking system and the choices of wary and indebted households and companies.

That this is all happening despite the massive efforts of the European Central Bank, which twice recently has made extraordinary amounts of nearly free money available to the banks, tells the grimmest tale of all.

As for the future, European banks still have hundreds of billions of capital to raise, implying that even when demand for credit returns, the unbalanced recession in the euro zone might be extended by continued tough loan market conditions.

Bank lending to euro-area companies in the real economy fell again in March, declining by €5 billion [$6.6 billion], an increase on February’s €2 billion {$2.64 billion] contraction, according to data released by the ECB on Monday. Banks instead took some of the inexpensive 3-year money they accessed from the ECB and increased their loans to governments by €29 billion [$38.22 billion].

That’s a decent, if painfully slow, way to allow banks to rebuild capital and nations to stay afloat, but it won’t work very well if economies contract in the meantime, as Spain’s dwindling GDP demonstrates.

If the bank loan drought was happening in the U.S., with its highly developed capital markets and ample cash sloshing around, this would be poor news; that it is happening in Europe, which remains highly dependent on bank funding for job growth and capital investment, is all the more concerning.

Interestingly this is not simply a story about timid banks which need to rebuild capital levels; there seems to be a bit of a turning away from credit by borrowers, doubtless because they see weak growth for their goods and services.

An April survey of bank lending conditions by the ECB showed falling demand for loans even as banks made them harder to get and sometimes more expensive.

Demand for loans to both households and businesses fell sharply in the month, driven by lower desire for fixed investment and, presumably, nervousness about house purchases due to the poor job market in many euro zone countries. Terms and margins both tightened for loans to households and businesses.

None of this, on either side, is terribly surprising. Many European banks are hugely overextended and undercapitalized and, outside of perhaps Germany, most firms and households are operating in uncertain and difficult conditions. This is how a balance-sheet recession works: there is a self-reinforcing cycle of people and businesses extinguishing debt rather than taking it on. Monetary policy and easy central bank loans are simply not terribly effective in breaking the cycle.

Somewhat in contrast, a separate survey of small and medium-sized euro zone companies showed that they were, if anything, more reliant on bank loans than before and more keen to take them out. This was due to a combination of generating less money internally and also partly as a precaution.

More small and medium-sized companies are being turned down and loan conditions, while not as bad as in the aftermath of the failure of Lehman Brothers, have tightened.

This doesn’t make the ECB’s LTRO a failure, but it does show how little of the more than €1 trillion [$1.318 trillion] in three-year loans the ECB doled out is actually hitting the real economy. One easy conclusion: we’ve not seen the last extraordinary attempt to hose out the banking stables. It might be another LTRO, or it might be another “bad bank” to eat the sins of the “good” banks, but the current trajectory really can’t be allowed to continue.

At least on the credit supply side, none of this is going to improve any time soon. An April report from the Bank for International Settlements gave a broad and sobering indication of roughly how much capital banks globally need to raise.

Large, internationally active banks, about one fifth of which are European, would need to raise almost a half a trillion dollars to meet recommended new capital targets under the Basel III plan. That’s nearly one and a half times their annual profits, so no easy task. While the study did not break down the results by country, it’s reasonable to assume many euro zone banks are among those with big capital needs.

As it will be very difficult to raise the required amount of capital, especially in the midst of a slow-moving but profound crisis, banks are likely to try to dispose of assets. That will put even more pressure on credit availability.

It is unclear what will break the self-reinforcing cycle between Europe’s credit crunch and its recession.

(Editing by James Dalgleish)

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