Delevering to disaster

Europe’s banks must not be allowed to wriggle out of the coming recapitalisation exercise by shrinking their balance sheets. Some lenders may argue they can boost their capital ratios by cutting lending or selling assets, and so don’t need to be stuffed with government cash. But, this could trigger an even more severe downturn.

From an individual bank’s perspective, deleveraging at breakneck speed could make sense, especially since the alternative is likely to be partial nationalisation. Not only would the banks probably have to sell equity at depressed levels, they might also have to suspend bonuses and dividends. That, at least, is what Jose Manuel Barroso, the president of the European Commission, has suggested.

But, what could be individually rational would be collective madness. The banking industry is deleveraging — and it needs to given the binge of previous years. However, it is already doing this so rapidly that some countries are arguably facing a renewed credit crunch. Stepping up the pace of this shrinkage is the last thing Europe’s economy needs.

Politicians should have no sympathy with devices designed to maintain bonuses or dividends. This is an industry which ran amok in the early part of the century and, since then, has received massive support. It’s quite right that capital should be preserved by cutting, if not abolishing, payouts to shareholders and staff.

How, though, can banks be prevented from excessive deleveraging? One option is to set a tight deadline for banks to hit a new capital target, forcing them to seek fresh equity rather than shrinking their assets. The alternative would be for policymakers to set an absolute figure for how much capital each bank must raise, rather than specifying a ratio of risk-weighted assets.

Say, Bank A was told it had to raise euro 3 billion, regardless of what it did on the deleveraging front. It would still be free to shrink its balance sheet. But, with the extra capital in its coffers, it would have far less incentive to do so.