Crunch time

Europe’s banks are feeling the squeeze — again. A wholesale funding drought, dollar shortage, and demands for higher capital ratios are prompting lenders to shrink their balance sheets. That’s bad news for companies and consumers in Europe — and around the world.

The first problem is a lack of wholesale funding. The euro zone’s sovereign debt crisis has made investors wary of senior bank bonds: With a few exceptions, the market has been closed since the summer. That’s troubling because European lenders depend on wholesale funding: outstanding loans account for about 120 per cent of the sector’s deposit base. Banks can partly fill the gap by issuing covered bonds, which are backed by assets such as mortgages. But smaller lenders don’t have a sufficient stock of high-quality assets. And while the European Central Bank provides short-term relief, it currently lends for no more than a year.

The crunch is particularly painful in Europe because companies and consumers still overwhelmingly finance themselves with bank credit: three-quarters of private sector financial assets in Europe are held by banks, according to the ECB.

But its effects are not limited to Europe. That’s because the continent’s banks are also having trouble getting hold of dollars. Many lenders previously relied on US money market funds to finance dollar-denominated loans, such as leasing and trade finance. These short-term funds have slashed their exposure to European banks, prompting a scramble for other sources of cash; the cost of swapping euros into dollars has reached levels not seen since the autumn of 2008. Banks like BNP Paribas and Societe Generale are now getting out of some dollar-denominated lending businesses. Mark Carney, governor of the Bank of Canada, last week warned that liquidity could dry up around the world.

Meanwhile, Europe’s bank regulators have made matters worse by demanding higher capital ratios. Though the recapitalisation is necessary to restore confidence, banks have been given until next June to meet new target ratios. With share prices in the doldrums, many are likely to respond by shedding assets rather than issuing equity. Morgan Stanley expects European banks to shrink their balance sheets by more than euro 1.5 trillion in the next 18 months.

Barring a sudden solution to Europe’s sovereign debt crisis the credit crunch looks unavoidable. The only question is how long it will last – and how widely its effects will be felt.