Like Diet & Exercise for Pneumonia

An important post at FT Alphaville from Izabella Kaminski regarding looming capital tightening at European banks this summer (bold passages are Kaminski quoting economist Richard Koo):

As a practical matter, the only way banks can satisfy the new capital requirements if raising capital is difficult is by reducing the denominator in the capital ratio: total assets. If all banks try to do that at the same time, the result will be a destructive credit crunch.

So, no new capital = need to sell-off assets = brand new credit crunch.

Hardly constructive.

And that, Koo says, is exactly what happened when stricter capital rules from the BIS were introduced in 1997 in Japan:

Although Japan’s bubble burst in 1990, it was not until October 1997 that the economy experienced a serious credit contraction. The decision by the Ministry of Finance’s Banking Bureau to unveil the details of new BIS-based capital rules on 1 October that year—a time when most Japanese banks were struggling under the weight of bad debts—triggered a destructive credit crunch. Discussions about the new BIS standards had been ongoing for a number of years, but it was the announcement of the specifics on new rules in October 1997, when the bubble’s collapse had left Japanese banks in an extremely weakened state, that prompted a major credit contraction.

It’s perhaps no coincidence then that the first mention of the [stricter capital rules for European banks] coincided with a marked deterioration of the crisis in the summer of 2011. Also, coincidentally, the moment when Italy became fully ensconced in the quagmire too.

It’s surprising in that context, says Koo, that no-one has yet called for a revision of the rule and/or government-led capital injections into the banking system ahead of the June 2012 deadline to discourage further asset sell-offs.

…not scrapping the [stricter capital rules], says Koo, could be the equivalent of telling a patient with pneumonia to do some exercise and to go on a diet.

While it’s possible that Europe can limp through the twin shoals of tighter capital requirements and the risk of private-sector haircuts on much greater swaths of troubled government debt, both of which will lead to renewed financial crisis and contagion, it seems just as possible that it will threaten to smash itself between the two.

As a result, we decided today to take off clients’ long positions in European equity funds for the time being, booking very small gains in the European Equity Fund (EEA) and the SPDR Euro STOXX 50 ETF (FEZ) since late January. While it may be premature, Europe still looks to us like a classic case of risk  outweighing potential reward.

Investors must also keep in mind that the European Central Bank’s Long-Term Refinancing Operation (LTRO) offered loans to eligible banks for no longer than three years. The LTRO, largely a life-support measure for bank and government balance sheets, will need to be extended, probably more than once, for European financial markets and economies to remain stable.

If the ECB issued sufficient net financial assets, and/or national governments were permitted to run large enough deficits, financial stability and economic growth would both be possible. But the current situation in Europe (as well as the United Kingdom) is eerily reminiscent of the lead-up to the Great Depression, when a nominal gold price target that was probably half of what is should have been—or said another way, a chronic and substantial shortage of net financial assets—forced national economies and their central banks into a game of musical chairs that eventually came unhinged.