Attard Montalto reckons that to reach the new loan-to-deposit (LTD) ratio, loans will be cut back rather than deposits increased. And here is a picture of the relative size of the problem – LTD ratios by country:
Source: Nomura
However, the indirect exposure of US banks to problem sovereign debt through derivatives, guarantees and commitments is much higher, totalling around US$493bn. If indirect exposure is included, US banks account for 18% of total foreign exposure. This is equivalent to around 5% of the total assets of US banks. That may still sound low, but losses of that size could cause the collapse of banks operating with low capital ratios. Exposure would also be unevenly distributed, with some banks more vulnerable.
According to data from the BIS, the stock of lending by western European banks to banks in emerging markets totalled US$3.6trn at the end of June 2011, equivalent to 71% of emerging market banks' total borrowing (that figure includes 19% accounted for by the UK). European lending dwarfed the US$765bn (15.1% of the total) loaned to emerging markets by US banks and the US$311bn (6.2%) loaned by Japanese banks. Eastern Europe relies on western European banks for over 90% of its banks' foreign funding. Banks in the Middle East and Africa are reliant on European bank lending for 82% of their foreign borrowing, while even banks in Latin America and emerging Asia source 68% and 53% of their foreign borrowing from western European banks, respectively.
European banks are ailing, exposed as they are to the sovereign debt of countries on the brink of insolvency. A series of failures among European banks would be likely to result in heavy losses for their own creditors. As a result, financial institutions around the world are getting understandably nervous about lending to them. The natural response by Europe's banks is to rein in their own lending to shore up their balance sheets. The upshot is going to be a recovery-stunting tightening of global credit conditions.
The global financial crisis gave us a lesson in how a crisis can spread between financial systems. Three years ago the sub-prime crisis spread from the US to Europe. In 2011 the stress has been crossing the Atlantic in the other direction. The US financial sector was hit harder than other industries by the stockmarket sell-offs in August. Then, in late October, MF Global, a derivatives broker, became the first major US casualty of the euro zone crisis, filing for bankruptcy after making heavy losses on its US$6bn portfolio of European sovereign bonds.
In October the Treasury Secretary, Tim Geithner, claimed that "the direct exposure of the US financial system to the countries under the most pressure in Europe is very modest." That's not strictly untrue, but it is a little misleading. The overall direct exposure of the US financial system to the debt of Greece, Italy, Spain, Ireland and Portugal is about US$147bn, accounting for only 6% of total foreign claims on those sovereigns, according to calculations by Goldman Sachs that are based on data from the Bank for International Settlements (BIS). European banks account for 89% of total foreign claims on the so-called PIIGS governments.
However, the indirect exposure of US banks to problem sovereign debt through derivatives, guarantees and commitments is much higher, totalling around US$493bn. If indirect exposure is included, US banks account for 18% of total foreign exposure. This is equivalent to around 5% of the total assets of US banks. That may still sound low, but losses of that size could cause the collapse of banks operating with low capital ratios. Exposure would also be unevenly distributed, with some banks more vulnerable.
These exposures also leave out lending to shaky European banks. Lending by US banks to French and German banks (which are collectively the largest holders of peripheral euro zone debt) is worth around US$1.2trn. Money-market funds are even more worried about their exposure to European banks. The ten largest US money-market funds alone had outstanding short-term loans to European banks worth US$285bn at the end of August 2011, equivalent to about 42% of their total assets, according to Fitch Ratings.
The exposure of money-market funds should not be taken lightly. They are the largest suppliers of dollar funding to non-US banks. In September 2008 the near-failure of the US$62bn Reserve Primary Fund triggered a run on money-market funds that caused enormous stress in global interbank and foreign-exchange markets, until the US government stepped in to bail out the sector.
Money-market funds are already moving to reduce their exposure to European banks: they reduced short-term lending to banks in Europe by 14% between the end of August and the end of September. The resulting stress is clear to see in the European interbank market, where the EURIBOR-OIS spread has widened to levels not seen since the 2008-09 global financial crisis, indicating that banks are getting very nervous about lending to each other.
For the moment, the move by money-market funds away from Europe is improving credit availability in some other areas. For example, Fitch reports that lending to Australia, Canada, Japan and some Nordic countries has increased. But money-market funds have also retreated into US Treasuries and US agency debt. If they continue their flight toward safety, financial institutions around the world will find it increasingly hard to obtain dollar liquidity. Central banks have responded to this threat by reactivating currency swap facilities set up during the 2008-09 credit crunch.
Reduced lending by European banks themselves could have an even bigger effect. The latest crisis has saddled Europe with the image of an impoverished debtor in desperate need of creditors. If that were wholly true, the risks facing financial institutions in other regions would stem mainly from the losses they might suffer on the money they have lent to their European counterparts (or, as in the case of MF Global, on derivatives that indirectly expose them to failures in Europe). But that doesn't tell the full story. The euro zone might be struggling to deal with a handful of crisis-plagued countries, but the bloc as a whole is actually an important supplier of credit to other regions, especially emerging markets. European banks have generally pursued growth by expanding lending into emerging markets. This is in contrast to the US, where banks have instead sought growth through securitisation of income streams, particularly mortgages (with well-known disastrous effects).
According to data from the BIS, the stock of lending by western European banks to banks in emerging markets totalled US$3.6trn at the end of June 2011, equivalent to 71% of emerging market banks' total borrowing (that figure includes 19% accounted for by the UK). European lending dwarfed the US$765bn (15.1% of the total) loaned to emerging markets by US banks and the US$311bn (6.2%) loaned by Japanese banks. Eastern Europe relies on western European banks for over 90% of its banks' foreign funding. Banks in the Middle East and Africa are reliant on European bank lending for 82% of their foreign borrowing, while even banks in Latin America and emerging Asia source 68% and 53% of their foreign borrowing from western European banks, respectively.
For economies that rely on foreign borrowing, the high proportion coming from Europe is a serious vulnerability. The claims of European banks on the Czech Republic were equivalent to 97% of Czech GDP in mid-2011, the highest ratio in the world. All of the most exposed countries by this measure are in eastern Europe. Chile, with liabilities to European banks worth 37% of GDP, is the next most exposed emerging economy, followed by South Africa (27%), Turkey (22%), Malaysia (22%) and Mexico (21%).
Asia and Latin America are less dependent on credit from western European banks, and their strong external positions afford some protection. That said, they would by no means be immune from a process of accelerated deleveraging by western European banks.
Reliance on European money is also becoming an important factor in the outlook for economic growth in many countries. As European banks find it difficult to raise funds themselves, and as they suffer losses on their assets, their natural response is to retrench. Moreover, the plan to recapitalise euro zone banks that was agreed in late October will require them to raise €106bn (US$146bn) in new capital by mid-2012. In a weak environment for equities, they will be reluctant to issue new stock to meet the requirements. Instead, they are likely to shrink their asset base by cutting their lending. The resulting crunch in global credit markets is going to make it harder for businesses and consumers all around the world to borrow, while the most exposed economies could flirt with balance-of-payments crises. In many ways, Europe's banks can do just as much harm to their debtors as their creditors.
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