Banks Need ‘Push’ to Avoid Prolonging Crisis, BIS Says

Banks will need a “healthy push” by governments to fix balance sheets, abandon risky businesses and serve the public to avoid prolonging the financial crisis, the Bank for International Settlements said.

Almost four years after the collapse of Lehman Brothers Holdings Inc., lenders still hold overvalued assets and are postponing necessary recapitalizations while relying on official funding, especially in Europe, the BIS said in its annual report released yesterday. Banks are also returning to risks akin to those that led to the crisis, it said, and governments need to put more pressure on them by enacting and enforcing new rules.

“Public policy must move banks to adopt business models that are less risky, more sustainable and more clearly in the public interest,” the BIS said in the report. “Governments can give the banking sector a healthy push in this direction if officials make sure that newly agreed regulations are implemented universally and without delay.”

Global regulators have warned that the U.S., European Union and Japan may fail to fully implement bank-capital rules drawn up to prevent a repeat of the financial crisis that followed Lehman’s collapse. Nations face a January 2013 deadline for implementing the new rules, which more than triple the core capital that lenders must have to stave off insolvency, and require banks to build up buffers of easy-to-sell assets.

‘Worrying Sign’

The BIS, based in Basel, Switzerland, is owned by 60 central banks for which it acts as a counterparty and trustee. It’s also hosting policy-making groups including the Basel Committee on Banking Supervision and the Financial Stability Board and provides research and statistics.

While the implementation of the new rules by the Basel committee is lagging behind, banks are still highly leveraged, partly because they continue to expect state bailouts, the BIS said. Another “worrying sign” is that trading returned as a major revenue source for banks, it said. In some emerging markets, credit and asset price booms have inflated banks’ profits in ways “reminiscent of advanced economies” before the crisis, it said.

“These conditions are moving the financial sector towards the same high-risk profile it had before the crisis,” the BIS said. “Recent heavy losses related to derivatives trading are a reminder of the dangers associated with such a development.”

Banking Union

Euro-area policy makers, who are in the third year of fighting a debt crisis that started in Greece, face the biggest immediate challenges, the BIS said. European banks are still weighed down by overvalued legacy assets that are a drag on profits and a cause for mistrust between banks that continues to clog interbank lending, it said.

Euro governments on June 9 budgeted as much as 100 billion euros ($126 billion) for a possible rescue of Spanish banks, which are creaking mostly under bad real estate loans and form the most acute epicenter of banking problems in the area now. The banks may need as much as 62 billion euros to withstand a worst-case scenario, auditors said on June 21. Spain is due to formally ask for the aid today.

The BIS joined the International Monetary Fund in saying that the currency union must create a cross-border banking system by unifying bank regulation, supervision, deposit insurance and the resolution of failing lenders. That could revive interbank lending and sovereign access to funding.

“A pan-European financial market and a pan-European central bank require a pan-European banking system,” the BIS said. “These measures will break the adverse feedback between the banks and the sovereign and other destructive links that are making the crisis so severe.”

‘Unfinished Business’

While European banks are the main focus now, market developments for lenders’ equity and debt worldwide signal that investors don’t see much progress in the global banking sector since the period following Lehman’s collapse, the BIS said.

“The magnitude of this unfinished business is clear from investors’ continued distrust of banks” the group said. “The cost of buying compensation for a bank default is as high now as it was at the peak of the crisis, and bank equities continue to lose ground relative to the broad market.”

The 43-member Bloomberg Europe Banks and Financial Services index fell 1.2 percent as of 9:45 a.m. London time today, led down by National Bank of Greece SA. (ETE) That takes its loss in the last 12 months to 26 percent, outpacing the 8.5 percent decline for the broader Bloomberg European 500 (BE500) index.

‘Asset Encumbrance’

While banks’ profits have recovered from their lows in 2008, that recovery was driven by trading income, a revenue source that proved to be fickle in the crisis, the BIS said. Net interest income, which remained mostly stable in the crisis, hasn’t change much, it said. Lenders also made only “modest progress” in lowering their costs, which will be a key requirement for profitability in the future, it said.

An increase in funding costs because of new regulations is inevitable, according to the organization. As banks pledge an increasing part of their assets as collateral for debt instruments such as covered bonds or for loans from the ECB, the remainder available for unsecured lenders shrinks. The withdrawal of government support and greater losses imposed on bondholders in case of a bank’s failure will also make funding more costly, it said.

Collateralized lending by euro-area banks, which includes bonds backed by mortgages, public-sector loans, and other assets, last year rose to 288 billion euros, or 45 percent of their total bond issuance, compared with 28 percent in 2007, the BIS said. Banks also are using more and more assets as collateral for ECB borrowing, it said.

Recovery ‘Headwinds’

Overall, 20 percent of European banks’ assets were “encumbered” one way or the other in 2011, the BIS said, citing industry statistics. For Greek banks, that ratio totaled a third of assets. While collateralized debt offers a way for lenders to secure market funding when unsecured debt is harder to sell, it makes the system more vulnerable to margin calls and less able to absorb shocks, the BIS said.

Shrinking asset pools also increase incentives for banks to use collateral as backing for several investments, it said.

“The shrinking supply of safe assets is harming the functioning of financial markets and driving up funding costs,” the BIS said. “And it is helping push banks into risky practices.”

While banks worldwide have raised capital ratios since 2008, they didn’t do so in the same fashion, the group said. Japanese and emerging-market banks continued to boost their assets as well as raising new equity, while U.S. banks slowed expansion and European banks shrank assets, which was necessary even as it cooled global growth, the BIS said.

“Even though such balance-sheet developments have generated headwinds for global economic recovery, they are consistent with a welcome downsizing of the banking sector over the long term,” it said. “Surely, fundamental progress on the structure of the financial system will be marked when its largest institutions can fail without the taxpayer having to respond, and when the overall size of the sector relative to the rest of the economy stays within tighter limits.”

To contact the reporter on this story: Boris Groendahl in Vienna at bgroendahl@bloomberg.net

To contact the editor responsible for this story: Frank Connelly at fconnelly@bloomberg.net

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