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Magical Money Can’t Fix Europe’s Banks

Spain’s largest lender says it has discovered a way to raise 4 billion euros overnight. The country’s second largest lender claims it can pull 2.1 billion euros out of a hat.

But, as most of us learned as children, money doesn’t appear at the wave of a magic wand.

The two Spanish banks, Banco Santander and Banco Bilbao Vizcaya Argentaria (BBVA), won’t actually be any richer as a result of their plans. They’ll just have different numbers in their spreadsheets.

The banks’ announcements came in response to an order from European regulators last month that requires banks to significantly improve their ratios of core capital to potentially risky assets by June. To fulfill the spirit of the law, banks would need to either raise new capital by selling assets and tapping shareholders, or they would need to curtail their lending. However, Banco Santander and BBVA, along with an assortment of other European banks including Germany’s Commerzbank and Britain’s Lloyds Banking Group, have said they will instead achieve at least some of the required improvement by simply changing their assumptions about the level of risk in the assets they hold.

The banks’ move is similar to the practice among pension fund managers of boosting funding percentages by changing assumptions about how liabilities will grow and assets will perform over time.

Regulations on capital ratios are an important part of the Basel Accords, which set international banking standards. Last month’s order, which required European banks to increase core capital to 9 percent of risk-weighted assets, would set them on the path laid out by the Basel III standards, established in the most recent set of agreements. Basel III will require banks to raise core capital to 9.5 percent by 2019. However, under the current Basel II standards – which have been adopted throughout most of Europe but not in the United States – banks have significant discretion in how they calculate risk within their portfolios.

This isn’t the first time European banks have offered up patently false optimism in the face of regulatory demands. Following the United States’ highly successful “stress tests” in 2009, Europe attempted a similar move toward transparency. But the results lacked credibility and accomplished little. In a second round of tests last summer, Europe’s banks blithely assumed that no nation on the continent would default on its sovereign debt, even as Greece was already on the verge of doing just that.

All of this numerical manipulation has a real impact on the economy. The crises sparked by Greece and Italy’s teetering finances can be weathered. But that will happen only if banks have enough capital to continue normal lending while they sift through the fallout, and if consumers and companies have enough confidence in the banks to continue conducting business. The banks, therefore, need to make authentic and visible efforts to strengthen their capital base.

Making assumptions that are obviously unrealistic simply puts off genuine change and undermines the public’s trust that change will come. As Mike Harrison, an analyst for Barclays Capital, told Bloomberg, “Gaming RWAs [risk-weighted assets] isn’t helpful, particularly if the objective is to convince the market to invest in banks again. The risk is that it’s counterproductive, because there is even less faith in what the banks are telling you.”

Regulators need to work with the industries they monitor. Industry insiders have unique expertise regarding how their businesses actually work, and can offer useful and necessary critiques. In the U.S., capitalization rules have also been an important topic of discussion recently, as banking executives, notably JPMorgan Chase CEO Jamie Dimon, have argued that the Basel III standards discriminate against American banks.

But in the end, regulators need to be the ones to do the regulating. As long as banks devise the rules under which they are assessed, the assessments can have no meaning. For Europe’s regulatory standards to work, regulators need to specify certain ranges of assumptions that they will accept as reasonable and force banks to change or justify formulas that imply too-rosy scenarios.

The idea that problems can be assumed out of existence is a big part of what allowed the global financial crisis to get so big and last so long. To bring that crisis to a close, banks need to change their methods, not their models.

It’s time for Europe’s banks to put away the wands and top hats. And it’s up to regulators to tell them that the time for magical illusions is over.

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