BRUSSELS (MNI) – Banks need to write off bad loans now and
authorities need urgently to recapitalize weak institutions to help the
banking sector make it through conditions that are comparable to those
last seen after the collapse of Lehman Brothers, the Bank of
International Settlements said in its annual report.

“An immediate priority is to ensure that banks burdened by legacy
assets repair their balance sheets by recognizing losses and
recapitalising,” the Basel, Switzerland-based international organization
of central banks said.

Efforts to strengthen banks’ resilience “have not succeeded” in
enabling banks to put their troubles behind them, the BIS lamented,
noting that equity and bond prices in 2012 indicate that “the general
conditions in the banking sector are similar to the conditions that
prevailed after the collapse of Lehman Brothers.”

Large European, US and Japanese banks raised the ratio of common
equity they hold against total assets by 20%, 25% and 15% between 2008
and 2011, the report observed.

The BIS said that although the European Central Bank’s cheap
three-year loans to the banking sector earlier this year helped lower
bond insurance costs on European government debt, the spread levels this
spring were close to and in some cases even higher than they were when
the U.S. investment bank failed.

European banks’ difficulties in raising short term funds have made
them increasingly reliant on asset-backed funding and the ECB,
increasing the proportion of those banks’ assets that would no longer be
available to unsecured bond holders should they fail.

In its report, the BIS said that “industry estimates indicate that
20% of European banks’ assets were encumbered” in 2011. In Greece the
proportion of encumbered assets soared tenfold between 2005 and 2011
while for Irish, Italian and Portuguese banks the ratio more than
doubled over the same period.

The need to pledge collateral in order to access funding
“strengthens incentives for firms to re-use collateral, pledging the
same primary asset several times so that it helps finance multiple
investments by different institutions,” the BIS observed. It warned that
the practice, known as rehypothecation, “undermines systemic stability.”

When the same asset is pledged to several parties, margin calls can
have much greater knock-on effects, the report noted.

To restore confidence in the banking sector, policymakers need to
“put pressure on institutions to speed up the repair of their balance
sheet” by encouraging them to recognize losses fully, and quickly, and
then raise capital, the BIS asserted.

“Banks’ stakeholders should bear the burden of losses associated
with balance sheet repair,” the report said, arguing that the practice
“would improve the credibility of official commitments to wean banks off
government support” and strengthen market discipline.

Although the underlying profits – excluding loan-impairment charges
– of banks in advanced economies have recovered from their 2008 troughs,
weak earnings figures in 2012 suggest that profit growth may not be
sustainable.

Many European banks, in particular Belgian, Dutch, French, German
and Italian banks, are retreating to their home markets and reducing
cross border lending, BIS noted. In total, banks from these countries
reduced their foreign positions by more than $6 trillion between early
2008 and end-2011. Foreign credit fell by more than $1.3 trillion or 14%
in the second half of 2011 alone, as fears of exposure to weak European
government bonds intensified, the BIS said.

Emerging market banks in general have held up better than their
developed-market competitors, stepping in to pick up market share in
some cases, but credit and asset booms also raise “questions about their
underlying strength” and the sustainability of their performance,” the
report said.

“The task of authorities in emerging market economies is thus to
ensure that prudential policy reflects rigorous, through-the-cycle
assessments of the banks’ riskiness,” the BIS said.

–Brussels Newsroom, +324-952-28374; pkoh@marketnews.com

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