How the Banking Crisis Affects the Real Economy

Today’s Markets and Money was going to be an exposé on how the government plans on protecting Australia’s resource wealth from a foreign invasion. But that will have to wait until tomorrow. What Australia has – commodity wealth – is strategically important. But what it doesn’t have – capital – is economically urgent.

The banking crisis will mean small Aussie businesses may start to feel the crunch of Europe’s credit crisis in 2012, according to Wesfarmers Managing Director Richard Goyder. “European banks have to comply with Basel III but they can’t raise capital, so they are shrinking their balance sheets by selling debt here to local banks, taking liquidity out of the market,” Mr Goyder told the Australian.

He referred to the example of French bank BNP Paribas. The French bank – perhaps anticipating the downgrade of French government debt – is winding back its lending commitments all over the globe. Here in Australia, BNP has withdrawn from its participation in the $3.7 billion Victorian desalination plant.

Now, before you go thinking that’s just common sense, given the desal debacle, BNP withdrew its financing of $2.1 billion for the financing of the Sevenwest Media deal. This is a sign that European banks are getting cold feet about the “syndicated loan” market. That’s where a bunch of banks pool their loans together to finance a project.

Mr Goyder says, “It’s not an issue for Wesfarmers because of our investment-grade rating, but it’s a real issue for SMEs (small and medium-sized enterprises).” He’s partly right. Big businesses (especially banks) will always get the benefit of a government guarantee or access to bank finance. It’s the smaller companies that won’t be able to get bank financing in a Credit Depression.

But it’s a global issue too. And that makes it an issue for Wesfarmers and every other blue-chip company and every blue-chip shareholder. This is how the Credit Depression impacts the real economy in a global way, through “trade finance”. Global trade between importers and exporters needs short-term credit from banks to thrive. If banks don’t fund that trade, it doesn’t happen. Real goods and services stop crossing borders.

Trade finance is what gives far-flung businesses the confidence to make deals with one another. “More than 90 percent of commercial transactions in the world require such credit, but the current crisis is forcing banks to hold on to capital and liquidity, leading to the lending market drying up and making credit more expensive,” according to AFP.

All this talk about liquidity, insolvency, and the choking off of trade finance is enough to make a banking regulator nervous. And sure enough, Friday’s Australian Financial Review led off with the headline “Banks told to prepare for the worst”. The article claims Australia’s banks have been given exactly one week by the Australian Prudential Regulator Authority (APRA) to, “model the impact of a worst-case scenario resulting in contraction in gross domestic product, an unemployment rate of 12 per cent, as well as a 30 per cent decline in house prices and a 40 per cent drop in commercial property values.”

That does not sound like a worst-case scenario. That sounds like the end of the world. In which case, a model is irrelevant anyway. The banks may as well have just replied: “We will be utterly destroyed.”

But at least one of the banks says that APRA has made no such request. On Friday, ANZ Chairman John Morschel told an annual general meeting audience that, “We’re not aware of any requests from APRA to complete a review on that basis within a week.”

There’s been precious little reporting on the story. But it’s an interesting idea. Why would APRA require banks to suddenly model an end-of-the-world financial scenario? We can only think of three reasons.

The first reason is that the regulator wants to see if the banks are up to it. Are the banks fat and contented with their multi-billion-dollar profits? Or do they allow themselves to be kept up at night by modelling a worst-case scenario? Maybe APRA is trying to scare the banks into better risk management.

A second reason is that APRA really is conducting stress tests. Typically, in our view, the purpose of a stress test is not actually to model a worse-case scenario. It’s to produce an “all clear” report on the banks that gives foreign investors confidence in Aussie bank debt and domestic depositors confidence that their money is safe. If that’s the case, APRA may think the banks need a boost in capital markets and that a clean bill of health would provide it.

A third reason is that APRA itself is a little alarmed. About what? About how Australia may be affected by affairs in Europe. For instance, the ratings agency Fitch said on Friday that it believes, “A comprehensive solution to the eurozone crisis is technically and politically beyond reach.” Fitch also downgraded its outlook on French government debt and put six other countries – including Spain and Italy – on negative ratings watch.

Why so busy, Fitch? From the UK Guardian

“In Fitch’s opinion, this [a comprehensive solution] requires more active and explicit commitment from the European Central Bank to mitigate the risk of self-fulfilling liquidity crises for potentially illiquid but solvent euro area member states… In the absence of a comprehensive solution, the crisis will persist and likely be punctuated by episodes of severe financial market volatility.”

That sounds about right, which means 2012 could be a lot like 2011. That sounds depressing. Fitch also spoke poorly of some major global banks. It downgraded Bank of America, Goldman Sachs in Barclays, BNP Paribas, Deutsche Bank and Credit Suisse.

So here we are at the end of the year. Banks lack liquidity, which they can get from central banks. But European banks especially are stuffed with government bonds, and that’s a solvency issue. Meanwhile governments themselves need more money…money they can hardly borrow from banks that don’t have it.

The solution to this riddle is obvious and has been staring us in the face all year. Tomorrow, all will be revealed, including a starring role for the Reserve Bank of Australia. Until then…

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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5 Comments on "How the Banking Crisis Affects the Real Economy"

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I have said for a couple of weeks now. I think we will discover in late February or early March (depending on when the RBA reporting cycle kicks in) that back at the end of November, they began purchasing Australian Bank (debt) Bonds because the banks had some (alot) maturing and needed rolling over, and no one wanted to lend to them, at any rate. There is a new Credit Crunch, specifically targetting European banks, but, the World over, all financial institutions are shoring up their asset bases, and Australian banks are not immune from its influence. Be it much… Read more »
Jeremy Britton DipFA SA(Fin) AAHA HH Dip(PH)
Jeremy Britton DipFA SA(Fin) AAHA HH Dip(PH)

Fourth reason for APRA planning a Worst Case Scenario: 2012 really *is* the end of the world… Damn those Mayans :-) Perhaps short banks and go long on tinned food?

Maybe part of the reason we are in this situation in the first place is that : a) People (re-inforced by economists) believe the only way to start or expand a business in with loans/credit and b) People believe these loans/credit should come from banks. Neither of these fundamental beliefs are true in any way ! Why not invest a portion of profits every month or year during good years into a fund that can later be accessed to fund expansion or new ventures, or save up part of your salary every month to finance the startup of you new… Read more »
The bankers plan to destroy the West is well underway – They create as much debt as they can for America and invest billions into the Far East and use their influence over the Far East to make it profitable for others to do the same with their money. The idea is to build up the East at the expense and destruction of the West. This is because these international bankers of London and New York have never considered themselves Western in the first place and they themselves originate from the East and hate the West. These Illuminati bankers of… Read more »
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