Unless forced to recognize losses, banks will gamble on redemption

Bloomberg ran an interesting article that shows that unless banks are forced to recognize the losses hidden on or off their balance sheets, they will continue to gamble on redemption.

Regular readers know that gambling on redemption is one of the many bad consequences of policymakers adopting the Japanese model for handling a bank solvency led financial crisis.

European banks pledged last year to cut more than $1.2 trillion of assets to help them weather the sovereign-debt crisis. Since then they’ve grown only fatter.... 

They have Mario Draghi to thank. 

The ECB president’s decision nine months ago to provide more than 1 trillion euros of three-year loans to banks eased the pressure to sell assets at depressed prices. The infusion, designed to encourage firms to lend, succeeded in averting a short-term credit crunch by reducing their reliance on markets for funding. It also may be making European lenders dependent on more central-bank aid. 

“Deleveraging isn’t taking place, especially in Spain and Italy,” said Simon Maughan, a bank analyst at Olivetree Securities Ltd. in London. “The fact that we haven’t got on with it, or very slowly, suggests that when the time comes we’ll need another ECB injection to roll over the first one, just to keep the balance sheets of Italian banks in business.”...

In the absence of transparency, banks would rather not absorb the losses hiding on and off their balance sheets.  Rather, they would prefer to postpone recognition of the losses in the hope that the borrowers will recover.

The ECB money has removed the incentive for banks to clean their balance sheets, according to Olivetree’s Maughan. 

“Some banks, especially in Spain and Italy, are just taking in the money that they can get from the ECB, which should be a short-term measure in order to enable them to manage while they implement structural reforms,” Maughan said. “It successfully staved off a funding crisis, but its real aim of facilitating restructuring hasn’t even started.” ....

Nor will a restructuring start until banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can identify all the bad exposures and put pressure on banks to address these bad exposures.

Banks trying to sell assets are finding that buyers are demanding steep discounts for their worst assets, according to executives at private-equity and hedge funds acquiring the loans. 

They’re seeking discounts of as much as 50 percent to face value for underperforming loans, said Andrew Jenke, a director at KPMG LLP in London who advises on such transactions. 

Selling a loan at a discount to the value marked on the books requires the bank to crystallize a loss that erodes capital.

Crystallizing their losses is exactly what the bankers are trying to avoid.

British and Irish lenders are selling the most because European Union regulators have forced them to divest divisions and loans in return for state aid....

And even with regulators putting pressure on them to divest divisions and loans, the banks are dragging their feet in complying.

Banks in other European countries have sought to sell performing loans, which carry higher prices, or some of their best assets to avoid taking too big a loss that would deplete capital.

How exactly is the banking system better off if banks sell of their performing loans?

Some also have changed their mix of assets to reduce the amount of capital they need to hold.... 

“What should we believe, the RWAs, that are often based on internal models, or assets defined by international accounting standards?” Nijdam said. “A reduction of risk-weighted assets doesn’t reduce funding needs. Only a reduction in gross assets does. French banks are still way too big to fail.”...

As the FDIC's Thomas Hoenig would say, this is just the big banks gaming the system.

Spanish banks, which will receive as much as 100 billion euros from the EU to boost capital, also may accelerate deleveraging after the government opens a so-called bad bank to take on souring real-estate loans from rescued lenders..... 

If Ireland and its bad bank is used as an example, Spanish banks will only shrink to the extent of the loans removed by the bad bank.

Analysts estimate the pace of asset sales will increase as banks face the next round of Basel rules, which go into full effect by 2019. 

To comply, lenders will need to raise about 400 billion euros of core Tier 1 capital, the highest quality of capital mostly made up of common stock, the EBA said. Firms may still try to meet that requirement largely by retaining earnings, which would be possible if profits remain stable, according to Panigirtzoglou. 

By providing money and removing the pressure on banks, Draghi has delayed necessary steps to shrink, Maughan said. 

“The banks are the weak link in the economy,” he said. “They have to be compelled to sell assets. If you let them do it in their own timeframe, they will wait.” 

That could lead to what RBS’s Gallo called the “Japanification” of the banking system, a prolonged period during which lenders are slow to clean up their balance sheets. 

Please reread the highlighted text as it nicely summarizes the problem with the Japanese model.  Without the market exerting pressure to clean up their balance sheets, lenders will wait.  This waiting drags down the real economy.