The way out of this financial crisis: the art of deleveraging

So last week we thought the Eurozone debt deal had been done. And on the face of it, it looked like good news, or at least the stock markets seemed to think so as shares rose across the globe. Of course the devil is in the detail and I would like to see just where the extra monies to support the stability fund were coming from. And will €1trillion be enough? Also the European Banking authority has said that the European banks must raise £91bn of new capital to protect themselves against losses resulting from any future defaults by June 2012 which seems rather a tall order. There certainly is a need to push the measures through rapidly to ensure confidence is retained in the markets.

But that was last week and as we now know, things have moved on swiftly, and not for the better, with the announcement of the Greek referendum which has thrown all Eurozone bail-out plans into chaos. Leaving aside the Greek issues and whether they will or will not be able to sort out the new challenge, it is worth looking at the underlying effects on the banks and the economies of rebuilding capital. This is not just a Eurozone phenomena, it is global.

I have to say I concur with the comments Mervyn King made to the Treasury Select Committee last week. He alluded to the fact that whatever decisions were made in Brussels, this would not be a long term solution but would only ‘buy a year or possibly two years breathing space’ and the ‘underlying problems hadn’t changed at all and they won’t change’. So is this just papering over the cracks then?

As I have mentioned before, the markets have never really been entirely fixed from the original credit crisis four years ago. The world prior to August 2007 was a very different place where it was commonplace for governments, banks, companies and even consumers to over borrow which in turn stimulated economies too much. This was made possible by a too optimistic view of continuing rising economies and asset values and was encouraged by relaxations to the capital and liquidity requirements of banks. This meant that not only were they able to lend so much more for any given €1 of capital but they also needed far less by way of a return on that loan to meet their threshold return on capital. Everything was set up to “over-stimulate” the global economies and that’s exactly what happened. This led to unsustainable asset price inflation which subsequently became an impossible situation when things went wrong. And with the beauty of hindsight we can see that this was always likely to happen.

Today banks are building up capital and liquidity to more realistic levels. Mervyn King mentioned that when the QE programme started, banks had a leverage ratio of 40 to 1 and now it is 20 to 1 so they are going in the right direction. However banks have some way to go; Mr King has expressed that he would like the leverage ratio to go lower. And that’s not just within banks but corporates and government too.

There are three main ways a bank can achieve this deleveraging: issue more equity capital, retain more profits as part of Tier I capital reserves or shrink loan books through deleveraging programmes. Europe’s biggest banks have ruled out tapping the equity markets to find this money. If they are not to call on more government bail-outs then they will have to trim their balance sheets. This will be evidenced by a combination of lending less (bad news for the economy as it will slow things up even more) and actively reducing assets from their balance sheets.

Active deleverage programmes are going to become more familiar to us all and we will see increasing incidences of banks actively “re-broking” their mortgage books out and encouraging borrowers to move their accounts away. We will also see an increase in mortgage and other asset sales if I am correct.

Some banks are managing their deleveraging programmes themselves but to manage this effectively calls for a wide range of key skills including cross-selling techniques, JVs with other lenders and of course corporate finance experience. This is not something that every lender will feel it has the ability to deliver so we can expect a growth in specialist asset management businesses like Home Funding which can manage this on an outsource basis in order to meet the banks’ overall strategic objectives and financial needs. It does seem to be a very pragmatic solution and we are going to see more and more of this type of activity going forward. However there is an art to this and the key is to get the balance right.

It would seem that wholesale deleveraging could help put the markets back on an even keel and I for one welcome it.