European banks were supposed to deleverage themselves last year by trimming $1.2 trillion in assets. But data from the European Central Bank (ECB) shows that banks actually increased their assets by 7% to the equivalent of $45 trillion.
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Early in 2012, ECB president Mario Draghi gave the banks over €1 trillion in loans payable in three years.
This enabled banks to hang on to assets they otherwise would have had to sell at a steep loss. The purpose of the funds was to encourage lending but the banks may have, instead, simply become more dependent on aid from the central bank.
Particularly in distressed countries like Spain and Italy, the deleveraging the ECB hoped for has not occurred. Banks may even need a second infusion to help them pay back the first round of funds.
European banks stated last year that they would cut over €950 billion in assets over a two-year period. Selling divisions and loans while trimming the amount of loans they make would assure investors they are reducing needs for short-term funding and accumulating capital.
As well, new regulations from Basel III that require larger capital reserves are contributing to banks’ larger balance sheets. The ECB’s LTRO (long-term refinancing operation) extended that time table to three years, loaning out €489 billion worth of three-year loans in first round aid and an additional round totaling €530 billion.
But the added funds were needed by the European economy. Lending to European households and businesses held steady this year instead of dropping. That has helped the Euro economy from experiencing abrupt and disorderly deleveraging.
Banks retained profit and replaced bad loans with other securities that had a better chance at rebounding in value.
By swapping distressed assets for assets of higher quality, banks reduce the amount of risk-weighted assets they hold, thereby reducing the amount of reserve capital required even as their balance sheets grow larger.
Some critics say that the ECB has removed all incentives for restructuring at the banks.
The funds should be considered short-term loans that allow banks to reform
their internal structures. Instead, banks have lapped up the short-term funding but little has been done on the long-term structural shift.
Deleveraging is still the single most important component of restoring the banks to health but banks are reluctant to sell non-performing assets at such a steep loss. They are also reluctant to truncate employees’ incentives to do business.
It's difficult for institutions to become leaner and meaner during recessionary times because they need the extra capital to continue operating and bank customers need access to credit to sustain daily life.