As the debt super cycle enters its final chapter, the world finds itself awash in debt. This debt pile is composed of public, private and financial sector obligations. In the U.S., households, companies and banks are far along the deleveraging process, but the federal government has increased its borrowing to compensate.
Europe has not really begun deleveraging. There has been very little change in private sector debt, government debt has actually increased and the banks have barely begun the process. A consulting firm claims that European banks have completed two-thirds of its deleveraging needs, but the chart above tells us something different. The truth is that European banks are stuffed to the rafters with questionable loans, which they cannot sell at sums close to their carry value. As such, deleveraging would wipe out their capital cushions.
The proposed capital and liquidity rules would have forced European banks to sell assets to raise cash for capital and liquidity buffers. Capital sales would have forced the banks to further curtail lending to both the private and public sectors. In that case, there would be no buyers left for the distressed sovereign debt of countries like Spain and Portugal, and no one to make loans for increased business activity.
Since the banks could not meet the new standards, the solution to the problem is to water them down. This has been accomplished in two ways. First, there will be a four year delay for the new Liquidity Cover Ratio (LCR) to take effect. Banks must meet 60% of their LCR need by 2015 with 100% funding delayed to 2019. Second, more assets will be deemed “liquid” for purposes of computing the LCR. Up to 15% of a bank’s LCR may be fulfilled by BBB- rated corporates. This change is a farce. During the last financial crisis, the only asset that remained liquid at reasonable market prices was sovereign debt, and this was prior to the eurocrisis.
The reason for the new rules is to create banks that are able to withstand crises. Since many banks could not meet these new standards, they are replaced by weaker ones. While this action will not strengthen the financial system, at least the banks may continue using leverage to keep struggling sovereigns afloat and keep nonperforming loans on their books at face value. The new rules may not fix anything, but they will allow the cover-up to continue.