Some European Banks May Be Using Lehman Brothers-Style Trick to Hide Debt

Last week, we reported on the mess in the European banking system, asking the question: could big European banks drag down the world economy? Big banks in Europe have piled up debt just like the rest of the world. But an article in Bloomberg reveals big banks in countries like Germany, Switzerland and France may be in even worse shape than we think. There are indications that European banks are using a Lehman Brothers-style trick to disguise their actual levels of debt. 

You remember Lehman Brothers, right? It was the fourth-largest investment bank in the US until it went belly-up in the fall of 2008. Most analysts say Lehmans’ bankruptcy was a major catalyst of the financial crisis and it gave rise to the “too big to fail doctrine.”

Lenders can use repurchase agreements (repos) to massage down assets as reporting dates approach. A repo works like this: the bank sells bonds or other assets to an investor and then buys them back at an agreed price after a very short term – weeks or even days. So, a bank can borrow short-term against some of its assets, agreeing to repurchase them after the term expires. The banks can then lend out the cash raised in a reverse repo. The collateral obtained in the reverse repo backs further borrowing. When the repo is closed out at the end of the quarter, the bank gets an infusion of cash that it can use to unwind the original repo. This shrinks the balance sheet and improves the lender’s leverage ratio – the ratio between capital and so-called leverage exposures. On the reporting date, the ratio will appear in line with regulatory requirements.

According to Bloomberg, Lehman’s used this trick to disguise its borrowings before its 2008 implosion. According to the Bank of International Settlements Annual Economic Report, some banks are doing it again.

The data indicate that window-dressing in repo markets is material … Data from US money market mutual funds point to pronounced cyclical patterns in banks’ US dollar repo borrowing, especially for jurisdictions with leverage ratio reporting based on quarter-end figures.” BIS analysts said the practice “reduces the prudential usefulness of the leverage ratio, which may end up being met only four times a year.”

In simplest terms, these banks are gaming the system to create an accounting illusion. This gives the appearance that they are in better shape with less debt than they really are.

A banks ability to effectively use this technique depends on the jurisdiction. US and British banks can’t do it because they must report leverage ratios based on daily averages. But many European countries, like France, Germany and Switzerland, only require end-period reporting. According to Bloomberg, the practice appears to be growing.

Since early 2015, when banks began reporting leverage ratios, the size of the swings in the volume of repo transactions carried out by euro-area banks has been rising, according to the BIS. Contractions in the repo market have soared to more than $145 billion at the end of last year from about $35 billion over the period, the BIS said.”

So, already knew that the many euro banks are in “lousy shape” as economist Dr. Thorsten Polleit put it. And now we know they may be even worse than we thought.

Polleit recently said we should “beware of big banks.”

This is what we could learn from the latest financial and economic crises 2008/2009. Big banks have the potential to take an entire economy hostage: When they get into trouble, they can drag everything down with them, especially the innocent bystanders – taxpayers and, if and when the central banks decide to bail them out, those holding fiat money and fixed income securities denominated in fiat money.”

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