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Oct 20, 2011 | 17:44 GMT

7 mins read

Special Series (Part 2): Looking Ahead in the European Banking Crisis

Editor's Note: This is the second installment in a two-part series on the European banking crisis. Special Series: Assessing the Damage of the European Banking Crisis

Risks to Recapitalization

Because of the politicized nature of European banking, European governments often require their banks to have a smaller cash cushion than banks elsewhere in the world. For example, when the European Banking Authority ran stress tests in July to prove the banks’ stability, the banks were only required to demonstrate a capital adequacy ratio (the percentage of assets held in cash to cover operations and losses) of 5 percent — half the international standard. Even with such lax standards, eight European banks still failed the tests. Since banks need cash to engage in the business of making loans, there is very strong resistance among European banks to valuing their assets at market values. Any write-downs force them to redirect their free cash from making loans to covering losses. The lower capital requirements of Europe mean that their margin for error is always very thin. Increasing that margin requires more cash reserves, a process known as recapitalization. Recapitalization can be done any number of ways, but most of the normal options are currently off the table for European banks. The preferred method is to issue more good loans so that profits from new business can eat away at the losses from the bad. But in a recessionary environment, new high-quality loans are hard to find. Banks also can raise money by issuing stock or selling assets. However, few in Europe, much less elsewhere, want to increase their exposure to the European banking sector, largely because of banks' gross exposure to Europe's sovereign debt crisis. European banks in particular, which are in the best position to know, are reluctant to become more entangled in each other's affairs and often shy away from lending to one another, even for terms as short as overnight. Even in good times, any serious recapitalization efforts would flood the market with stock shares and assets for sale. These are not good times. Remember that banks are the primary purchasers of European sovereign debt and Europe is already in a sovereign debt crisis. Adding more assets for banks to buy would create the near-perfect buyer's market: rock-bottom prices. There are indeed some would-be purchasers — Sweden from within the European Union and Turkey and Russia from without — but their combined interest adds up to merely billions of euros, when hundreds of billions are needed. Which brings us to the sheer size of the problem. The Europeans are leaning toward a new regulation that would force all European banks to have a capital adequacy ratio of 9 percent, hoping that such a change would decisively end speculation that Europe's banks face problems. It will not. According to the European Banking Authority, the institution that is responsible for carrying out stress tests, two-thirds of Europe's banks are currently below the 9 percent threshold — and that assumes no past or future reduction in the value of sovereign bonds for any European governments, no new sovereign bailouts that damage investor confidence or asset values, no mortgage crisis, no new bank collapses in Europe akin to that of Franco-Belgian bank Dexia and no renewed recession. Simply increasing capital adequacy ratios to 9 percent will cost about 200 billion euros (about $270 billion). The regulation also assumes that all European banks have been scrupulously honest in their reporting; Dexia, for example, shuffled assets between its trading and banking books to generate a misleading capital adequacy ratio of 12 percent, when the reality was in the vicinity of 6 percent. Forcing the banks to have a thicker cushion is certainly a step in the right direction, but the volume is insufficient to resolve any of the problems outlined to this point, and the latest rumor out of Europe's pre-summit negotiations is that perhaps only 80 billion euros is actually needed. If the banks cannot recapitalize themselves, the only remaining options are state-driven recapitalization efforts. Here, again, current circumstances hobble possible actions. The European sovereign debt crisis means many governments are already facing great stresses in meeting normal financing needs — doubly so for Greece, Ireland, Portugal, Italy, Belgium and Spain. No eurozone states have the ability to quickly come up with several hundred billion euros in additional funds. Keep in mind that, unlike the United States, where the Federal Reserve plays a central role in bank regulation and remediation, the European Central Bank has no role whatsoever. The individual central banks of the various eurozone states lack the control over monetary policy to build the sort of highly liquid support mechanisms required to sequester and rehabilitate damaged banks. Such central bank actions remain in the arsenal of the non-eurozone states — the United Kingdom, for one, has been using such monetary policy tools for three years now. However, for the eurozone states, the only way to recapitalize is to come up with cash — and as Europe's financial crises deepen, that's becoming ever harder to do.


There is one other option that the eurozone states do have: the European Financial Stability Facility (EFSF), better known as the European bailout fund, which manages the Greek, Irish and Portuguese bailouts. With its recent amendments, the EFSF can now legally assist European banks as well as European governments. But even this mechanism faces three complications. First, the EFSF has yet to bail out a bank, so it is unclear what process would be followed. The French have indicated they would like to tap the facility to recapitalize their banks because they see it as being politically attractive (and not using just their money). The Germans have indicated that should a bank tap the facility then the sovereign that regulates the bank must commit to economic reforms; the EFSF, therefore, should be a last resort. Not only is there not yet a process for EFSF bank bailouts, but there also is not yet an agreement on who should hold the process. Even if the Germans get their way on the EFSF, remediation and supervisory structures must first be built. Second, the EFSF is a very new institution with only a handful of staff. Even if there were full eurozone agreement on the process, the EFSF is months away from being able to implement policy. And if the EFSF is going to have the ability to restructure banks, that power is, for now, directly in opposition to EU treaties that guarantee all banking authority to the member-state level. Finally, the EFSF is fairly small in terms of funding capacity. Its total fundraising ceiling is only 440 billion euros, 268 billion of which it has already committed to the bailouts of Greece, Ireland and Portugal over the course of the next three years. Unless the facility is significantly expanded, it simply will not have enough money to serve as a credible bank-financing tool. To handle all of the challenges the Europeans are hoping the EFSF will be able to resolve, STRATFOR estimates the facility will need its capacity expanded to 2 trillion euros. Finding ways to solve that problem likely will dominate the European summits being held during the next few days.

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