European banks could be forced to shed as much as $3.8 trillion in assets through 2013 and curb lending if governments fall short of their pledges to stem the sovereign debt crisis or face a shock their firewall can’t contain, the International Monetary Fund said.
In a study of 58 banks including BNP Paribas SA and Deutsche Bank AG, the IMF forecast that under such circumstances, gross domestic product in the 17-country euro region would be 1.4 percent lower than now expected after two years. Even under its baseline scenario, the IMF sees banks’ combined balance sheets possibly shrinking by as much as $2.6 trillion.
“So far, deleveraging has occurred predominantly through buttressing capital positions and reducing non-core activities, leaving the impact on the rest of the world manageable,” the IMF said in its Global Financial Stability Report released today. “It is essential to continue to avoid a synchronized, large-scale, and aggressive trimming of balance sheets that could do serious damage to asset prices, credit supply, and economic activity in Europe and beyond.”
The Washington-based IMF sees a resurgence of Europe’s debt turmoil as the biggest threat to global growth even after steps taken by governments and the European Central Bank helped ease tensions in financial markets. The challenge for policy makers is to make sure banks keep lending to companies and individuals even as they boost capital to comply with regulators’ requests.
Banks in the sample studied by the IMF reduced assets by almost $580 billion in the last quarter of 2011, it said.
Governments should complete and extend the measures already agreed upon to reassure investors if they want to limit the impact of banks’ deleveraging, the IMF recommended. That includes continuing to reduce budget deficits while supporting demand as much as possible, restructuring banks and having the region’s rescue funds inject capital directly into them, it said.
“For an effective monetary union, deeper integration is required,” the IMF said. “Fiscal arrangements will need to be redesigned to accomplish ex ante fiscal risk-sharing,” without which “countries will continue to face very different financing conditions and remain prone to having liquidity crises turn into solvency concerns.”
While it may be too early for a Eurobond, “euro bills” with maturity of less than a year would be a good first step, IMF Chief Economist Olivier Blanchard said during a press conference yesterday.
The IMF’s recommendations come as Managing Director Christine Lagarde seeks to boost the fund’s lending capacity from around $380 billion to shield the global economy against a deepening of Europe’s debt turmoil. She won pledges of fresh cash from Japan to Denmark over the past two days, adding to promises by euro nations to total about $286 billion.
“Many countries, notably in the euro area, have embarked on the process of fiscal consolidation to reach safer positions, but this effort will take many years,” the IMF said.
“In the meanwhile, sovereigns remain exposed to sudden shifts in investor perceptions that can tilt the balance from a good equilibrium -- which features low funding costs and affordable debt -- to a bad equilibrium -- where funding becomes very costly or even unavailable, reviving default risk.”
Spain’s 10-year yields have jumped more than one percentage point since Prime Minister Mariano Rajoy said on March 2 that the nation won’t meet a budget deficit target for this year.
Analyzing funding costs, the IMF found that Italy and Spain face challenging situations. The average interest rate on Italy’s debt would rise to 5.3 percent by 2016 if current yields are maintained, the IMF said.
Outside Europe, Japan and the U.S. “continue to benefit from very low interest rates despite rapidly growing debt stocks which, even under the baseline, are making them more vulnerable,” according to the report. “Fiscal challenges are by no means confined to the euro area.”
While the impact of European bank’s deleveraging on emerging markets has been manageable so far, the IMF saw a risk that cross-border lending could further decrease, with emerging Europe as the most vulnerable region.
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