WHEN THE WISE MAN POINTS AT THE MOON… (I), by François Leclerc

Guest post. Translated from the French by Tim Gupwell.

The chaotic ups and downs of the deleveraging process continue inexorably, affecting not only the debt of the member states but also a European banking system which is now in the same mess. What it had been concealing has now been revealed: it is in a very sick and feeble state.

In order to subdue and contain this gradual process, new bail-out instruments have had to be put in place – which are the subject of much debate; their effectiveness is limited since they are part of a debt-reduction strategy which relies predominantly on the staggering of its financing with public funds that are more or less mutualised. What is new about all this is that, as the amount required increases, it is becoming increasingly difficult to raise the funds. This is prompting a consolidation of the private sector (in order to limit the damage and to share the costs), which is, in turn, destabilizing this sector as well.

The banks are confronted with numerous combined threats, factors contributing to a reduction in their activities and their profitability. This is due as much to the new regulatory constraints that they are striving to minimize, as to the burden of past errors (which just won’t go away), or to the economic recession which continues to worsen. The result is an greatly increased fragility which, now that it is being revealed in the light of day, requires a reinforcement of capital ratios and liquidities which banks cannot manage by themselves (as they have had to be discounted). We will not mention the decisive intervention of the ECB, which will sooner or later have consequences. Certainly, the sector cannot all be tarred with the same brush, but due to their interconnectedness the weakest banks risk also dragging down those in better shape. Not managing to generate sufficient results, they busy themselves selling off their activities and their assets in order to reduce the size of their balance sheet and reduce their indebtedness, observing an increase in the costs of financial resources and not wanting to further reduce their yields nor dilute their share capital. In a position of force, they bargain a weakening of regulatory constraints in return for maintaining credit to the economy. When it is not blackmail for employment, it is blackmail for credit.

Earning less from their traditional activities due to the contraction in economic activity, restricting the availability of collateral to use as a guarantee for investors (who are increasingly exacting about their quality), the banks have little left to turn to other than to try to compensate by venturing into riskier markets in an attempt to improve their results. But in this way, they only serve to further prove the need for the capital ratio and liquidity requirements from which they are trying to extract themselves. These measures seem even more justified in as much as one of the pillars supporting the fragile banking equilibrium is not what it was: sovereign bonds are no longer at zero risk as they used to be.

The banks are also attempting to sidestep these new rules, playing on the quality of the assets recognized as core capital as well as the definition of measures aiming to reinforce their liquidity. At the same time, knowing themselves at risk of further sovereign debt restructures for one or several countries, they are trying to organize themselves so as to be better placed to forestall them and to organize them in ways more to their liking.

To this effect, the convention of the Institute of International Finance (IIF) has just created a “joint committee for the strengthening of the framework for sovereign debt crisis prevention and resolution”, the presidency of which has been entrusted to Jean Lemierre, who cut his teeth on the Paris Club, before negotiating the restructuring of the Greek debt with Charles Dallara. This new structure brings together not only the representatives of finance but also of central banks, of the European Stability Fund (ESF), and the representatives of several administrations or financial ministries. The systematic implementation of Collective Action Clauses (CACs) is one of its key tools, which allows a restructuration to be made compulsory for all creditors if accepted by a qualified majority.

With the States no longer willing to continue to bail out the creditors via rescue packages, as is the case for Ireland, Portugal, and Greece, these creditors are now first in the firing line and have to prepare their succession plans. Chaotic restructuring must be avoided at any cost and they need to have the means to anticipate their negotiation. It is either that, or accepting the procedure of orderly sovereign debt restructuration – entitled SDRM (Sovereign Debt Restructuration Mechanism) – which had been studied by the IMF and which must be buried. That’s what called cutting ones losses.

The banks are also trying – certainly in the case of the British jewels of the City – to reorient their activities towards less heavily regulated and more economically prosperous playgrounds, essentially Asian. The others, more reliant on their domestic markets, cannot follow this movement.

(To be continued)

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