Forbearance: Underappreciated, But Not Forgotten

 |  Includes: FXE
by: Marc Chandler

The major economies are recovering, but their debt burden remains substantial. The regulatory regime for banks has tightened. Many economists, including Rogoff and Reinhart, in a paper at the end of last year, warned that the high income countries may still have to adopt policies that have been more common in developing countries, like debt restructuring, capital controls, and/or higher inflation to lower the debt burden.

Not inconsistent with this, but slightly different, many observers may not be recognizing the importance of forbearance. Forbearance refers to a special agreement between debtors and creditors to ease the burden debt servicing to increase the probability of repayment. It also refers to officials easing the implementation of rules and regulations.

There are many purists, usually among the creditors, that insist on the sanctity of contract. As Keynes wrote nearly a century ago about Germany, and as Europe prepares for the spring local elections and EU parliamentary elections, "the absolutists of contracts are the real parents of revolution."

The heavy debt and regulatory burden, a reflection of and correction to past mistakes darkens the future. Keynes warned then, and seems applicable now that "we shall never be able to move again unless we can free our limbs from these paper shackles."

In the lists of possible actions to reduce the debt burden, the power of forbearance seems generally under-appreciated by many observers and economists. However, policy makers seem to be gradually moving in this direction.

Two recent developments come to mind. First, Basel regulators have agreed to dilute a planned debt limit for banks and modify a rule to make it easier for certain types of central bank loans to count toward regulatory capital requirements. Banks will be given greater scope to use "netting" accounting practices to calculate its leverage ratio. The rule modifications will ease the terms under which banks determine the size of their off-balance sheet activities. The regulatory disincentives for trade finance have been relaxed.

Last September, the Basel Committee warned that a full quarter of the large global banks would have failed to meet the leverage limit if it had been operational at the end of 2012. Before the forbearance granted recently, estimates suggested banks would have to raise up towards $200 bln of capital to meet the capital requirements.

The second development is a less intentional act of forbearance, but circumstances may force Europe's hand. The issue here is bad-debt classification. It sounds like it ought to be straight forward, yet it is anything but. The problem is that the definition various widely through the region. In particular, countries have employed different rules on classifying loan terms that have been modified to take into account changes in the borrowers' income, for example.

It is widely recognized that the European Economic and Monetary Union has stopped well shy of a fiscal union, but the numerous and conflicting national practices suggest that the monetary union itself is incomplete.

This issue is coming to a head because the ECB is preparing to assume the regulatory authority over 130 banks in the euro zone in Q4 this year. As part of its preparation, it conducting an asset quality review and, later this year, a stress test. Bloomberg is reporting that an internal ECB document shows officials are concerned that even not all countries will be able to comply with even the kind of rigorous definition that would be credible and engender confidence in the process, which was sorely in deficit in past tests.

There, ECB is willing to use a simplified rule of the European Banking Authority (EBA) that defines as non-performing all loans, debt securities, financial guarantees and other commitments that are 90-day past due. The ECB document says that a majority of countries can supply such data. On the other hand, the more stringent standard, that includes data on the ability and likelihood of the borrower to repay, could only be met by half the countries.

ECB officials have indicated that more information on the treatment of non-performing loans and the stress test rules later this month. The EBA's more complex definition remains the goal, but the ECB seems to be prepared to grant forbearance in the form of using the simplified rules first.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.