Deleveraging Leveraged Banks

In the banking word a leverage example follows a process like the one described below (this overly simplified version of leveraging is called securitization and was first introduced in the US as early as 1970): 

1. A Bank with 100euros in deposits lends 80euros to the public.

2. Since the 80euros were lent to a broad spectrum of individuals and companies a combination of these would mean that the risk of all defaulting simultaneously would be zero. (That is unless a macroeconomic shock hits the economy). Thus the bank issues a bond over those loans (i.e. receives a cash payment of 80euros now and agrees to repay the investors willing to participate at some future date, including interest payments until that time)

3. The bank, using the cash proceeds from the bond issue provides more loans to individuals or businesses

4. Repeat steps 1 until 3, up to the point the bank has reached the core Tier 1 benchmark set by regulators

This process essentially means that banks have "overlend" themselves or, in the finance lingo, they are leveraged by a large factor. In an article in the Wall Street Journal it is stated that most investment banks believe the banking sector must shrink by about €2 trillion to reach a size that would be considered as adequately capitalized. Over the last year non-performing loans rose by more than 10% to over than €1 trillion as a study by PWC indicates  (IMF's definition of a non-performing loan is: “A loan is nonperforming when payments of interest and principal are past due by 90 days or more, or at least 90 days of interest payments have been capitalized, refinanced or delayed by agreement, or payments are less than 90 days overdue, but there are other good reasons to doubt that payments will be made in full”. In essence a non-performing loan is one in default or nearing default) 

What does this mean? It means that many large European Banks are starting to sell their non-core loan portfolios in order to limit their exposure to the non-performing ones. In Britain, Lloyds has sold £1 billion worth of non-core loans to investors, in France, Société Générale SA is about to sell an asset management subsidiary and Crédit Agricole SA is planning to sell Emporiki Bank in Greece. Even in Cyprus, the troubled Bank of Cyprus (not to be confused with the Central Bank of Cyprus) and Popular Bank are evaluating proposals about trading their Greek loan portfolio.

On one hand, this seems good for the banks' solvency, however, measures should be taken in order for this kind of situation not to occur in the future. Legislators need to impose regulations concerning the amount of leverage a banking institution may have at any given point in time. Nevertheless, these laws should not be implemented at present, as in combination with the current situation they will wreck havoc rather than benefit the economy.

Excessive leverage should not have been allowed in the first place, but as bank profits soared and no problems were visible then, (remember that humans are very short-sighted creatures) this was thought as a good policy to promote investment throughout the world. The thought was that if a bank's core Tier 1 was within certain limits (now about 9%) then everything would be fine. It seems that the problem is found not only in South European banks but in Germany as well, where Deutsche Bank is considered the most leveraged bank in Europe (its balance sheet being as large as 80% of Germany's GDP).

Let's hope that the deleveraging procedure will continue, as this would make the banks more able to cope with any future discrepancies in the Union, where politicians do not seem to agree to help the EU survive.