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Capital markets: Europe’s markets must thrive

With its banking system in decline, Europe must support the capital markets as providers of credit.

The European Banking Authority calls its latest stress test – the third analysis of European banks quickly following a second in July that gave a clean bill of health to Dexia just weeks before it collapsed – "Measures to restore confidence in the banking sector".

Although the EBA had already lost nearly all credibility, at the end of October it finally bowed to the reality that investors in bank debt and equity are already assessing banks’ soundness after calculating losses from applying prevailing mark-to-market prices to government bonds held in banks’ hold-to-maturity banking books.

These were previously exempt from markdowns in stress tests. But banks had disclosed their holdings and investors had done their own calculations.

Imagine what would happen if bank regulators now took the next logical step and removed the zero-risk weighting on sovereign bond assets on banks’ balance sheets. Instead they might apply a rising range depending on the fundamental credit quality of each sovereign borrower with, say, a 20% risk weighting for de facto double-A rated sovereigns, a 40% weighting for single-A rated countries and higher for triple-Bs or lower-rated government borrowers.

This would win back some respect for regulators from investors in bank debt and equity. It might even restore confidence in banks, once they had disgorged bad assets to restore their capital ratios.

Governments would not be too happy of course. Such a move would kick out the bank stuffees that have supported sovereigns’ swollen funding programmes. So don’t expect this to happen soon.

But regulators must address the absurdity of their insistence that banks build large buffers of supposedly highly liquid and risk-free government bonds that have turned out to be neither. This policy has created a bubble and, following the law of unintended consequences, has increased banks’ riskiness, not reduced it.

There have even been little-noticed stresses on banks that are not at the centre of the sovereign storm. Swiss banks, for example, have only a small Swiss franc government bond market to build liquidity buffers from and, with this market heavily overbought, have been forced to incorporate other countries’ government bonds into their buffers. This brings with it higher credit risk, FX risk and, where this has been hedged, counterparty credit risk.

It’s no surprise then that investors in bank debt are scornful of bank regulators’ efforts to ‘restore confidence’. They have been making their own assessments of bank balance sheets, partly using disclosures on sovereign bond holdings mandated by regulators. Banks that investors refuse to fund will now shrink. Some will disappear.

Governments will have to find some other source of funding for themselves to replace the banks, putting them in the same boat as many other borrowers, including many of Europe’s small and medium-size enterprises. A Eurostat study released at the end of October shows that SMEs enjoyed just a 65% success rate in loan applications last year, down from 88% in 2007. It’s not immediately clear how much of this decline stems from reduced creditworthiness through a wrenching recession and how much from reduced willingness and capacity of banks to lend.

One thing is clear, however. European borrowers both big and small now need capital markets investors to step forward as providers of credit, as the banking system in Europe declines.

In between sovereign borrowers and SMEs stand large corporates, many with strong balance sheets, good credit ratings and large cash balances. They already enjoy easy access on good terms to the markets. In future, policymakers need to consider what contribution they can make to extending the capacity of investors to fund lower-rated borrowers. In the UK, Bank of England governor Mervyn King has suggested fiscal incentives for lending to SMEs.

From the earliest days of the European single currency, it seemed that its greatest success had been as a vehicle for a larger pan-European capital market for issuers to raise funds in. But banks retained their role as core intermediaries, borrowing heavily in the wholesale capital markets, often short-term, benefiting from their implicit government guarantee and recycling the funds raised into longer-term loans.

If the banking system has not quite been broken by this crisis, it is much diminished already and will be further. It is easy to look at the US financial model, where capital markets provide most credit, as the one to which Europe must now move as the inefficiencies in its banking system are washed away. The path towards that destination looks less clear.

The diminution of the banking system itself makes it hard to follow. In conventional credit securities markets liquidity is poor even compared with that in the discredited credit default swap market. Dealers are withdrawing from making markets and those that remain are running as light on inventory as they possibly can. Investors will suffer from this absence of liquidity.

Policymakers must now begin to pay much more attention to supporting liquidity in the core debt and equity markets and to promoting the long-term role of asset managers in all their forms and insurance companies in allocating and pricing debt capital to potential users.

If the banks can’t do it, somebody must.

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