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    Will Europe face credit contraction?

    Fatih Özatay, PhD08 December 2011 - Okunma Sayısı: 1027

    As calculations of the newly established European Banking Authority suggest, total capital gap of European banks amounts €106 billion.

    There are a few days before we learn the third quarter growth rate. Next year’s growth performance is of course of higher importance. All estimations including the official one declared in the Medium Term Program state that Turkey’s growth rate will decrease considerably in 2012. The level of growth and the risk of economic contraction relates closely to developments in Europe.

    As calculations of the newly established European Banking Authority (EBA) suggest, total capital gap of European banks amounts €106 billion. Banks are given time until June 2012 to close the gap. But they are not required to improve their capital by this amount; they are required to achieve a core capital ratio of 9%. 

    Balance sheets might be downsized
    The main difference between the two options is that in the former, banks have to acquire €106 billion additional capital whereas there is no such requirement in the latter. They can achieve 9% core capital ratio solely by downsizing their balance sheets (that is, by lowering their assets) without obtaining any additional capital. The latter option therefore means that banks will have to lower credit supply remarkably. As credits become riskier, banks are asked to provide higher levels of capital. One calculation goes like this: Assume that the average risk weighted assets of European banks is 40%. Then, instead of obtaining additional capital worth €106 billion, banks can reduce credit volume by €3 trillion (106 divided by 9% and result divided by 40%). This corresponds to 10% of Europe’s gross domestic product! It is an extreme-case assumption that capital requirement will be met completely buy downsizing assets. Banks can also meet a part of this need via partners or retained earnings. However, even if these are taken into account, total drop in credit volume is expected to be minimum €0.5 trillion.

    Those who expect a larger drop in credit volume refer mainly to two factors: first, they argue that the additional capital requirement is actually higher. Second, for some time now, European banks have been facing difficulty in generating funds via selling securities. One scenario estimates that the amount banks generated during 2011 was €144 billion less than the amount due on securities by 2011. In other words, banks not only failed to generate funds via selling securities but had to access additional funds as they became net debtors. What is more, it is maintained that the picture has been worsening since May 2011. Monthly average fund inflow via sale of securities decreased to €20 billion during June-October 2011. On the other hand, debt on issued securities due by 2012 amounts €700 billion. Therefore, it is argued, banks will have to lower credit volume by a higher ratio. All these scenarios reveal that the decision for financial union taken at the end of the European leaders’ summit on December 9th was insufficient. It is needed to force banks to access fresh capital and as a means of last resort, states must provide funds. For this to happen, it is needed primarily to strengthen the European Financial Stability Fund and to agree using part of the funds for capital generation for banks or state contributions, if deemed necessary. In addition, it is stressed that the Fund providing warranty for bank securities will help banks raise funds with this method. Another suggestion is that the EBA requires banks to generate additional funds worth €106 billion within a defined timed frame - a month, for example. It must be noted that troubled countries also face problems in borrowing via their treasuries.

    The moral of the story is that, European banks might lower the credit volume remarkably. This implies that the European economy will contract and lower imports on the one hand, and that fund outflows from European banks to emerging countries like Turkey will diminish on the other. It appears that this will be the main determinant of Turkey’s growth in 2012. Unfortunately, countries that have a low savings rate are highly responsive towards external developments.

     

    This commentary was published in Radikal daily on 08.12.2011

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