A drastic contraction of European bank balance sheets during the next 18 months could jeopardize financial stability and economic growth in Europe and beyond, according to forecasts from the International Monetary Fund. In its Global Financial Stability Report, published on Wednesday, the fund warned that European banks looked set to shrink their balance sheets by $2.6 trillion (2 trillion euros) over that period. Unless officials improved their policy response, the IMF said, European banks would dump almost 7 percent of their assets by the end of next year. The IMF expects most of the deleveraging to come from sales of securities and non-core assets. However, it also sees credit supply shrinking by 1.7 percent as banks rein in lending to businesses and households hitting the broader economy. After examining the efforts of the continent's 58 largest banks to boost their capital ratios, shed unprofitable businesses and cut their reliance on wholesale funding, the fund's analysts predicted the deleveraging process would be more severe than previously anticipated. While acknowledging that balance sheets needed to shrink after the financial excess seen in the run-up to the crisis, the IMF warned that the risk of a “synchronized and large-scale deleveraging" could spark financial instability and hit economic growth. “The highly uncertain European policy backdrop is driving banks to keep shrinking, even if we avoided a disorderly and abrupt crunch," warns Huw van Steenis, banking analyst at Morgan Stanley. The fund said better policies – such as a consideration of more easing by the European Central Bank and further structural reforms, as well as progress on bank restructuring and resolution – would prompt a smaller, 6 percent contraction in banks' balance sheets, which would boost euro-area growth by 0.6 percent. José Viñals, director of the monetary and capital markets department at the fund, said: “The key is to recapitalize, restructure and resolve." “Restructuring is fundamental," Mr Viñals said, adding that banks that were “not viable" had to be closed. Mr Viñals said the region hit hardest by the deleveraging would be emerging Europe. But other emerging markets would not escape unscathed. “While emerging markets generally have substantial policy buffers, such an external shock could combine with homegrown vulnerabilities and further undermine global stability," Mr Viñals said. The warning comes a day after Olivier Blanchard, the fund's chief economist, called for taxpayer-funded bank recapitalizations to be put back on the policy agenda to counter the risk of a painful deleveraging. Wednesday's report echoes Mr Blanchard's recommendation, saying that the European Financial Stability and the European Stability Mechanism should be able to inject capital directly into banks “to break the pernicious link between sovereigns and banks". “The important thing is whether the European Stability Mechanism should have the ability to directly take stakes in banks," Mr Viñals said: “That is what we are advocating." The fund notes that the degree of deleveraging predicted by the GFSR assessment is “much larger" than that implied by plans submitted to the European Banking Authority as part of the regulator's efforts to ensure all major European lenders' high-quality capital buffers amount to at least 9 percent of assets by the middle of this year. The EBA identified a collective 115 billion euro shortfall in December, on the back of which 28 of the region's most poorly capitalized banks submitted plans on how they would raise their capital ratios. According to the EBA, only 3 percent of the recapitalization needed would come through deleveraging. However, the fund noted that the differences arose because its analysis was “fundamentally different" from the EBA's in several ways. It looked at nearly twice as many banks over a longer time period and examined the impact of market forces and funding stresses, as well as the EBA's demands for additional capital. “The purpose of the EBA exercise is to increase banks' capital positions; it is based on a single capital target. The GFSR exercise, however, is driven by a range of structural and cyclical factors," it said. The EBA and IMF assessments assume the bulk of deleveraging will occur through the form of asset sales, rather than a drop-off in lending. Andrea Enria, chair of the EBA, said earlier this month less than 1 percent of the deleveraging represented true cuts to lending. The IMF also vindicates the EBA's controversial call for banks to hold at least 9 percent capital by finding evidence that higher equity buffers and capital ratios boosted banks' share prices. “Banks with higher tier one capital outperformed other sample banks during the European sovereign debt crisis," it said, adding that a 1 percentage point increase in a bank's capital ratio during the past two years added 0.5 percent to monthly stock returns. Elsewhere in the report, the fund warned of the risks presented by an ever-decreasing stock of “safe" assets. “The number of sovereigns whose debt is considered safe is declining – taking potentially $9 trillion in safe assets out of the market by 2016, which is roughly 16 percent of the projected total." It expects this trend to inflate prices for the few remaining assets deemed to be safe, Financial Times reported.
