10 January 2012

FN: A rough guide to surviving the great deleveraging of 2012

As European banks stumble into 2012 they are facing a monumental challenge to meet demanding new targets for reducing the leverage that had fuelled their outsize returns of the decade before the financial crisis. It won't be pretty.

Big European banks face a deadline of June 30 from the European Banking Authority to increase their core Tier-1 capital ratios to 9 per cent, equivalent to raising €115 billion in equity. In theory, banks can meet this by retaining profits, raising equity or shrinking assets. But with equity markets all but closed to banks and earnings falling, a crash diet to reduce their bloated balance sheets is the only realistic option. Analysts expect that the great bank deleveraging of 2012 could see as much as $2 trillion to $3 trillion of assets trimmed from European banks’ balance sheets – or about 5 per cent of total assets – with damaging consequences not only for the banking industry but for the fragile European economy.

Here is a rough guide to some of the inevitable consequences – some deliberate, some unintended and some obscure – of this deleveraging on the investment banking industry.

Death of profits, jobs and banks
The most obvious impact of deleveraging will be the devastation it will wreak on the profits of investment banks.

A mystery on Wall Street
The barrage of regulatory change is moving at different speeds on different sides of the Atlantic, meaning that the divergence in how investment banks disclose their numbers will become wider than ever. This will see many European banks posting a surge in their risk-weighted assets and allocated equity when they report their 2011 results, making comparisons with previous years, and with other banks, harder than ever.

Game theory
One thing we have learned from the crisis is that it is dangerous to leave a bunch of clever bankers in a room to work out how to get round a problem. One way to reduce leverage is to play around with how you calculate your risk-weighted assets. In a process that is known disingenuously as “RWA optimisation”, banks can remodel the risk profile of their assets to reduce their RWAs.

Pointing fingers
It is hard to see how shedding $2 trillion in assets will not have an impact on the underlying economy by reducing the availability of credit while simultaneously increasing its price, but one thing is for sure: banks and governments will continue to argue with each other over what the impact will be.

Pay to play
Whatever the impact, credit will become more expensive. And nowhere more so than in the corporate loan market. A similar effect is taking place in trading, with investment banks sharply reducing their trading inventories and the levels of capital they are prepared to commit for clients.
 
Casting a shadow
In many cases, the buyers of assets offloaded by the banks have come from the shadow-banking system of hedge funds and structured investment vehicles. While individual firms in this sector are not systemically risky, the aggregate risk building up in the shadow banking system is harder to quantify and to monitor.

Go east
While Asian markets have this year failed to live up to the hopes invested in them, in the medium to long term the deleveraging of US and European banks could play in Asia’s favour.

The Promised Land
In all of this, there is some good news. For those banks that can survive the rigours of deleveraging without having to pull out of entire regions or businesses while retaining a profitable operation, there is a Promised Land on the other side. Overcapacity in the investment banking industry will be whittled away to leave a smaller number of bigger and (relatively) more profitable global banks whose scale will increasingly play to their advantage.


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