Europe fearing a lost decade.

“We should not come away from the crisis thinking that expanding access to finance is bad. In general, expanding access is beneficial (just not before a crisis!), but finance is a powerful tool that has to be used sensibly. Access is good; excess is bad”  Raghuram Rajan

For my benefit I interpret “Access to finance” to narrowly defined term “Access to credit”, equities account for 55% of capital resources in both the U.S. and Europe, but European banks are much more important to the economy, accounting for about 70% of financial resources allocation (versus about 20% for U.S. banks). The key difference is that the U.S. has a deep, liquid and vibrant corporate bond market, which has also allowed companies to bypass the banking system to obtain financing at times of severe banking crises and credit crunches. This is a key reason why the U.S. economy has sprung back much more quickly from the 2008 Great Recession than either Europe or Japan, where economic activity is held hostage by banking retrenchment.

One fear is going forward, the credit crunch in Europe will get worse before it gets better. European banks are not as well capitalized, but much more leveraged than their U.S. counterparts, and the credit crunch in the euro area has barely begun. According to a Mckinsey study “Basel III could significantly change the composition of banks’ Tier 1 capital; risk weights, especially in trading books; and capital ratios. New McKinsey research estimates that the effect of these new rules on Europe’s banks would be a capital shortfall of about €700 billion" this mean either they raise capital of €700 billion or reduce assets by €7 trillion or a mix of both. What’s more, Basel III’s proposed new standards for liquidity and funding management would constrain funding severely. Mckinsey estimates that European banks may be required to hold an additional €2 trillion in highly liquid assets (LCR) and to raise €3.5 trillion to €5.5 trillion in additional long-term funds (NSFR). At present, European banks have only about €10 trillion in long-term unsecured debt outstanding.

Unlike in Japan, the European credit crunch will be compounded by severe public austerity (not only GIIPS but France, Netherlands and UK also), creating a potential downward spiral in output. According to often cited work of Reinhart and Rogoff “This time is different: Eight Century of financial folly” a country which enter into recession followed by financial crises sees on an average 86% increase in sovereigns’ debt/GDP ratio, and once an economy crosses debt/GDP ratio of 90% every it start losing 1% growth from its potential.

So the risk that Europe goes though its own version of a lost decade is not trivial.