When Banks Shrink so Does Economic Gowth

Something unusual happened in Europe at the beginning of 2016: the banking authorities actually implemented an important regulation. Of course the regulation in question should have been operational long before the 2007/8 financial crisis (in which case the crisis may not have happened on the first place). Given the speed at which decisions are made in Europe we should be happy that consensus was reached nearly a decade after the crisis. The Bank Resolution and Recovery Directive (BRRD) established a common way to deal with troubled banks across all 28 countries of the European Union. In short it takes the risk of bank failures away from governments and makes it the problem of shareholders as well as large depositors. Common sense prevailed as it usually does after governments and taxpayers are made to pay for the lessons learnt.

Markets also took their time but eventually also figured out that more risk to bank capital means that the cost of bank capital should go up. What this means in practice is that banks’ share prices should fall and they did. The big names like Barclays, Deutsche and Credit Suisse are all trading 30% – 50% lower than a year ago. Tougher regulations - which should have been seen as confidence by authorities in the market - were rewarded by capital flight.

Offshore Banks Since 04/15


Image Source: Thomson Reuters

Of course the unintended consequences of logical regulations don’t end there. Bank management, astutely recognizing not only that their share options are under water, also realize that raising capital through rights issues at discount prices would only infuriate their long-suffering shareholders. Alternatively they can beef up their own capital by cutting dividends but that too would not go down well at the board meeting. So the only game left in Eurotown is to shrink balance sheets and to do so it means lending less.

Ironically less lending is the exact opposite of what the European Central Bank (ECB) wants. The ECB’s interest rates are at historic lows and it is printing money at an equally furious rate. This amounts to nothing if the credit taps are being closed. Economic growth is simply not stimulated by the bombardment of liquidity.

On top of it al there are knock-on effects outside the EU as banks try to divest from their non-core assets. Barclays for example has now announced what was long rumoured namely that it wishes to sell down its Africa unit, thinking it can make a better return on capital in its slower growing home region. Time will tell. But it is regulatory action rather than Africa pessimism that is guiding the decisions in London.

Meanwhile South African banks have a similar problem in that their cost of capital could soon increase. The difference in our case is that higher costs are imposed not by regulators but by ratings agencies. By definition SA banks cannot be rated higher than the SA government. So if SA is downgraded so are our banks and that means more expensive loans and slower economic growth.

Money matters. And without confidence money does not flow. What needs fixing now is not monetary policy or banking regulation but real, structural reform that makes economies grow. In this the EU and SA are no different. We cannot print our way to greatness.

Local Banks Since 04/15


Image Source: Thomson Reuters

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