How big is too big for a banking system? It is a question that has been posed many times since the 2008 crisis when the phrase 'too big to fail' entered the lexicon as taxpayers were forced to bail out their banks or face financial meltdown.
Eurozone banks, despite shrinking their balance sheets by $3.9tn since May 2012, are still more than three times the size of the 17 economies using the single currency.
Alberto Gallo, head of European macro credit research at Royal Bank of Scotland, reckons this is still too large. In a recent research note, he argues that despite shrinking by 8% eurozone banks are only halfway to reaching sustainable levels and need to 'deleverage' by a further $4.25tn.
Some $875bn of this will come from the 11 largest banks but the bulk of it – $3.45tn – will come from the smaller institutions, which will find it harder to 'deleverage' as quickly as the bigger banks.
This deleveraging can take place in two main ways. Either banks raise capital (by tapping shareholders or holding on to their profits, say) or they can reduce their assets by pulling out of business lines and cutting back on lending.
In practice they do a combination of the two and Gallo estimates that the 11 major banks will need to raise $62.25bn of capital. If the UK's banks are added then the total amount of extra capital needed is $79bn – and that is on top of the $875bn reduction of assets the banks need to do in the next three to five years.
Gallo's calculations are based on 70% of the deleveraging coming from raising capital and 30% by reducing assets. But for the smaller banks he estimates that only 30% can be achieved by raising capital. This begs the question of how the banks finance a recovery in the eurozone while they are drastically shrinking their balance sheets. Gallo points out that policymakers in Europe have already devised a scheme intended to help bolster lending to small and medium-sized businesses by up to $132bn in the next six years.
But deleveraging is necessary if banks are to become smaller relative to the size of economies and to meet tougher rules being imposed on banks. Gallo reckons a better sized – and safer – banking system would be two to three times bigger than GDP. Banks in Canada, Australia and Japan are around twice the size of their domestic economies, he points out, while in the US banks are smaller than the size of the economy, partly due to the fact that big companies go straight to the bond markets to raise money to a greater extent than they do in other countries.
For the UK Gallo's charts show that the banks are five times the size of the economy. He argues that this includes big international players and stripping out half of HSBC, 90% of Standard Chartered and 70% of Barclays, the UK banking system becomes about 3.5 times the size of the economy. This makes Gallo less worried about the UK banking system than that of the eurozone. Still, the numbers seem too big.
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