Banks to weigh on Europe economy despite G20 reprieve

VIENNA (Reuters) - The delayed introduction of stricter capital rules agreed by the G20 buys Europe time, but the fact remains that its economies are much more exposed to the state of their banks and more at risk if credit gets tight.

In Toronto on Sunday, the G20 endorsed a more flexible timeline for building up banks' capital and liquidity levels, giving some breathing room to those that say they are still struggling after the global recession.

The delay is a success for intense lobbying, particularly by European banks, which say the shift to stricter rules by 2012 would have imposed huge capital-raising burdens on banks and jeopardized lending and the economic recovery.

Euro zone banks' combined assets dwarf those of their U.S. counterparts, and the sector provides the bulk of debt financing in the region.

However, policymakers overseeing the drafting of the new rules say the trade-off for the longer phase-in is that the rules will not be fundamentally watered down. That means the banks still have to increase capital and liquidity eventually.

On top of that, European banks face new taxes and may even have to raise capital before the new rules kick in to appease markets that remain less convinced than regulators that their capital levels are sufficient.

All this is likely to push up prices for loans in the future -- although by how much is debatable -- and even limit banks' lending capacity, potentially choking the main motor of Europe's growth over the past decade.

REGULATION IMPACT ON EUROPE

There are a number of reasons why the tighter bank capital rules known as Basel III will have a greater knock-on effect on the economy in continental Europe than elsewhere.

Firstly, the euro zone's banking sector is huge and central the functioning of the economy. Its total assets are almost four times those of the U.S. banking sector, and 3.5 times euro zone gross domestic product. Three-quarters of all debt financing is provided by banks, compared to one quarter in the United States.

In addition, European banks are almost twice as highly leveraged as their U.S. counterparts while they have on average much less core capital.

Euro zone banks are also disproportionally affected by some of the proposed rules and may have to raise more fresh capital and even more fresh liquidity than U.S. rivals, while more of them are unlisted and have no access to equity markets.

On top of that comes the bank levy that Europe may raise even though a deal on a global tax was firmly rejected by the G20 after opposition led by Canada, Australia, Japan and Brazil.

Finally, all this comes as European governments prepare to reduce public borrowing to rein in budget deficits, which in theory would call for an expansion of private sector leverage that could be curtailed by the new rules.

The banking lobby group Institute of International Finance (IIF), which earlier this month presented the first attempt to gauge the impact of the banking rules on the broader economy, says that new regulations would cost the euro zone 0.9 percent in annual growth over the next five years.

This compares to 0.5 percent less growth in the United States over the same period and 0.4 percent for Japan.

This impact is also likely to spill over to the former Communist part of Europe, the IIF says, as banks are dominant as a source of funding there too, and the lenders are the same western European banks under pressure from the new rules.

A PRICE WORTH PAYING?

European banks therefore complain that the rules, instead of just targeting the kind of casino capitalism that prompted the crisis, will undermine traditional banking and the kind of plain vanilla lending that keeps Europe's companies humming.

However, the flip side of the argument that Basel III is more expensive for Europe in terms of growth foregone is that the stability of banks is also even more important in Europe.

And the lack of pushback by European politicians against the rules betrays rising doubts amid billions of euros of bailout money about how conservative European banks really are.

After all, even plain vanilla lending can feed a bubble -- witness the Spanish savings banks that fueled the housing boom on the peninsula or the Austrian retail banks that provided cheap loans in Swiss francs and euros to emerging Europe.

"The previous (European) expansion that we saw from 1995 to 2008 was driven by an expansion of debt and worsening capital positions," said Charles Cara, an economist with Absolute Strategy Research.

"Saying growth will be lower but comparing this with growth that was unsustainable is a bit misleading," he said.

(Reporting by Boris Groendahl; Editing by Patrick Graham and Hugh Lawson)