Time for debt restructuring

The longer the financial stresses resulting from the European crisis persist the greater the chance some EU banks will fail

The concept of stress tests originally derived from the procedures used to ensure the robustness of complex engineering structures. In 1995, a financial stress test was initiated by the Madrid-based International Security Commission, which was then adopted by the International Monetary Fund as a tool, particularly during a financial crisis, to assess banks' ability to address major "black swan" events or shocks. It is an important measure that aims at restoring market confidence.

The authorities in the United States and Europe have frequently conducted financial stress tests since the global financial crisis in 2008, yet given the situation in Western countries has developed from a banking crisis to a sovereign debt crisis, and from a economic crisis to an institutional crisis, even an ideological crisis, the stress tests are obviously not enough to fix the banks.

In a new round of stress tests in December, the European banks were shown to be weaker than previously thought, with a capital shortfall that had risen from 106 billion euros ($135 billion) in October to 115 billion euros. Even for Germany's banking system, its capital shortfall was nearly triple the result of a previous test, raising the prospect of further taxpayer bail-outs.

The first quarter of 2012 will be crucial for the eurozone, as a large volume of bank and government debt is due for refinancing; banks across the region have been locked out of public funding markets in recent months due to fears of a worsening European sovereign debt crisis.

Banks are reluctant to lend to each other except for overnight borrowing, and the short-term interbank markets or money markets are drying up. Money-market funds in the US, regarded as a big source of dollars for the European banking system, have reduced loans by more than 40 percent in the past six months.

The worst scenario is money leaking from banks in peripheral countries, such as Greece, where depositors have been shifting their money for the past year, and Italy and Spain, where savers have now begun to do the same. This will further drive up borrowing costs and tighten credit conditions.

In order to ease the strain, the European Central Bank (ECB) offered an unprecedented 489 billion euros in three-year loans to banks across the region. This move temporarily cheered the markets, but it will have little effect in averting the credit crunch, because banks may take the cheap ECB loans to buy higher-yielding government bonds, rather than supporting the real economy. In 2009, about half of the 442 billion euros in one-year loans from the ECB was used to buy sovereign debt, mostly Greek and Spanish government bonds.

Although Italy saw its six-month bills selling at an average yield of 3.25 percent before Christmas, falling by half from 6.5 percent, the trading was so thin that it is unlikely to prop up the government.

Financial stresses will continue. The sharp tightening of credit conditions is being felt far more widely than just the eurozone. The Organization for Economic Cooperation and Development (OECD) says that the gross borrowing needs of OECD governments is expected to reach $10.5 trillion in 2012, a $1 trillion increase on 2007 and almost twice as much as in 2005. The risks are greater than ever because of the rising borrowing costs in turbulent, unpredictable markets.

The European banks' US branches are using up their cash and are losing access to the US markets for funding, forcing them to borrow dollars from home to sustain their overseas business operations.

In contrast to the European banks struggling to fund themselves, US banks appear to be relatively healthier because they do not have much exposure to the Europe's troubled sovereign debt, making it possible for them to escape the squeeze so far. But US banks are not immune to the European debt crisis, and the contagion has really hit the US commercial mortgage-backed securities market due to European banks selling assets.

There is no doubt that as long as investors are convinced that Europe's crisis will remain unsolved, the financial stresses will continue. Therefore, restoring their faith in European governments and banks is paramount.

Austerity is painful, but it is a must for the heavily indebted countries, which will mean large declines in living standards for a period.

More action is needed from the central banks. At the end of November last year, some central banks introduced new measures to ease a shortage of dollars in the banking system, but further efforts are needed to help the banking system raise longer-term funding so that it can lend to customers for longer periods.

Whether we like it or not, debt restructuring, the so-called haircuts, may be inevitable. And if that is the case, it is best done quickly.

Financial stress tests have been a catalyst for banks to raise capital and for regulators to curb banks' dividend pay-outs and executive bonuses. Officially, the Basel 111 rules phase in over a nine-year period, but many banks have been forced to achieve the standards by 2013 either through raising fresh capital or cutting risk-weighted assets. That could pose a threat to the real economy and financial markets; therefore, it is worth keeping a good balance between them.

Recovery in the advanced economies remains feeble, and emerging economies are beginning to feel the slowdown. The process of deleveraging is picking up pace across the globe leading to a sharp drop in demand in advanced countries. It is impossible for emerging markets to rescue the world by filling the gap left by the developed nations.

The great danger is that the global downturn will exacerbate the financial stresses, creating a further vicious downward spiral. And the longer the financial stress, the bigger the chance banks will fail.

(China Daily 01/11/2012 page8)