Comment: Banco Espirito Santo | capital buffers

WHY the big panic in the markets over Portugal’s Banco Espirito Santo? OK, some firms in the family holding company to which Espirito Santo belongs have just missed debt payments. But Portugal’s central bank has long since ring-fenced Espirito Santo itself.

Senior Portuguese officials gave assurances Friday about the soundness of Portugal's biggest bank. Picture: AP

The true reason for the share wobble in New York and London has everything to do with the perilous state of the EU economy, as exposed by this week’s economic data. The wheels on the German export locomotive have started to slip badly. Industrial output in Germany has now dropped for three successive months, as its Asian markets dry up. Stock markets were calmer on Friday but the warning lights still flash in Berlin.

For the last couple of years the European Central Bank (ECB) has managed to persuade international investors that it has put out the eurozone fire. As a result, US and Asian funds have sunk circa £525 billion into European equities and bonds. 
If they get a hint that Europe’s recovery is stalling, expect a scramble for safety.

True, the ECB is about to pump an extra £800bn of cheap money into the eurozone’s banks, in a bid to boost lending and growth. But don’t uncross your fingers just yet. If previous such exercises are anything to go by, Europe’s banks will take the money and load up with sovereign eurobonds.

Which, of course, ties Europe’s wobbly banking system even closer to nation states struggling with austerity and deflation, while doing precisely nothing for lending to the private sector. And remember: deflation magnifies the real debt burden, making national balance sheets even more precarious. No wonder that even a modest whiff of trouble in a Portuguese bank has foreign investors heading for the exit door.

Delusions of safety in raising leverage ratios

IN THE light of this week’s events on the continent, it’s significant that the Bank of England is considering forcing “systemically important” financial institutions in the UK to hold even larger capital reserves.

As it is, some British banks had to scramble to meet the new 3 per cent capital-to-assets ratio that came into force at the start of this year. Now Mark Carney – whose short stint at the Bank of England has been characterised by a succession of policy gyrations – wants to up the ante considerably. The Bank is conducting a “consultation” with a view to raising the leverage ratio to 4 per cent or even higher.

Do the maths: big banks will have to increase reserves by a third – or cut lending.

And remember, the reserves are measured against all assets, not just risk-weighted ones (to stop cheating). Of course, the big US banks face a 5 per cent leverage ratio, as US legislators seek revenge for the carnage of 2008.

My worries are twofold. First, bigger lifeboats do not prevent ships sinking. The political focus on leverage ratios will prove dangerous if it deludes 
regulators and politicians into thinking that banking crises and credit bubbles are less likely and so can be ignored.

Second, draconian leverage ratios can actually encourage excessive risk-taking, paradoxical as that sounds. Reserves, by definition, add little or nothing to the bottom line. As a bank’s leverage ratio is counted against all assets, the best way of protecting profits is therefore to invest more in higher-earning, riskier assets. So goodbye Treasury bills.