Economist Magazine asks: How much capital do European banks need?

The Economist Magazine ran an article in which it asked:  How much capital do European banks need?

Readers will notice that in answering the question, the Economist highlights many of the issues raised by this blog including:

• Before deciding if and how to recapitalize European banks, market participants need to be able to figure out which banks need to be recapitalized;

• In the absence of information to determine which banks are solvent and which are not, market participants are perfectly capable of assuming a need for more capital than banks currently hold or that their host countries might be able to provide.

From the article,

THE fire raging in Europe’s financial system is growing fiercer by the day. Banks across the region have been unable to sell any long-term unsecured bonds since early July. Short-term markets have also been closing to some banks.... An obvious step to douse the flames would be to recapitalise European banks. Yet by how much and with what capital?

This blog has repeatedly pointed out that without current asset and liability-level disclosure, market participants are left to guess the current condition of each bank.  How much capital a bank needs to raise is dependent on this guess.

Why are regulators making market participants guess what are knowable facts?  Do they think that investors are more likely to invest in the absence of facts?

The alternative is to use 21st century information technology and provide market participants with access to all the knowable facts.  With these facts, all market participants analysis begins at the same starting point.

Global regulations are already forcing banks to plump up their cushions significantly. Nomura reckons that simply getting banks to comply with the new Basel 3 rules, plus an additional surcharge on globally important banks, could leave European lenders, Britain’s included, needing to raise more than €100 billion ($136 billion). 

In theory banks have until 2019 to raise this amount, and much of it could come from profits over the next few years....

On top of this requirement is the extra capital that banks would need to absorb losses from a recession or the debt crisis. Such calculations depend on lots of assumptions, from the amount of capital that banks ought to hold to the precise nature of any euro-zone write-downs. 

Actually, with current asset and liability-level disclosure, many of the assumptions go away and are replaced with market values.  For example, why guess at what a write-down might be when you can use a price that the security recently sold for in the market.

The use of market values allows market participants to determine who is solvent and who is insolvent where solvency is determined by comparing the market value of the bank's assets to the book value of its liabilities.

A good estimate of the amount of additional equity a bank requires is the amount that the book value of its liabilities exceeds the market value of its assets.  It is only after the shortfall between the market value of the assets and the book value of the liabilities has been determined that attention should be turned to how and when to cover the shortfall.

As this blog has frequently noted, there are many alternatives for raising this capital and, equally importantly, so long as market participants think the bank has a viable franchise and the regulators do not close the bank, a window of time in which to raise the capital.

“The key issue is what scenario the banks would need to be recapped for,” says Huw van Steenis of Morgan Stanley. “A soft restructuring in just Greece? Or restructuring in multiple peripheral countries?” 

Start with a Greek write-down and the numbers look quite manageable. Even assuming a 50% reduction in the value of Greek government bonds, the total hit to the capital of non-Greek banks in Europe would probably not exceed €10 billion. Simply buffering the system against a Greek default may not be enough, however. 

Investors now fret about the solvency of bigger countries. If banks were to undergo a recession and mark to market their holdings of bonds issued by Greece, Ireland, Portugal, Spain and Italy, they would need more than €300 billion in capital. 

Banks have several options for boosting their capital ratios. One is to cut assets. The benign way to do so is by selling them. On September 28th Crédit Agricole became the third of the big French banks to say that it would sell some assets to bolster equity ratios. The harmful way is to stop lending. Some analysts forecast a fall in lending across peripheral countries of 10-15% by the end of 2012. 

Asset sales need buyers, however, and slimming balance-sheets takes time. Raising lots of money quickly may require more rights issues. The trouble is that institutional investors have little appetite for more shares in European banks, even at seemingly attractive prices. Indeed, low share prices make it harder for banks to raise meaningful amounts of money without wiping out existing shareholders. Volatility also makes a rights issue risky, even for relatively strong banks. 

Might sovereign-wealth funds from the Middle East or Asia ride to the rescue, much as they did after the 2008 meltdown? Many of these state-owned investors lost significant sums during the subprime crisis and are wary of investing too soon this time, say bankers who have been meeting with them. At best they are likely to buy stakes in only a handful of the region’s strongest banks. 

If push came to shove, other European banks would probably have to be recapitalised by governments. Among the bigger economies, Germany and France would be able to muster the cash but Italy and Spain might need help, perhaps from the euro zone’s bail-out fund. 

That raises yet another series of complications. The first is that national bank bail-outs would increase state borrowing relative to GDP, which could raise question-marks over some sovereign credit ratings. There is also the risk that European competition regulators could force recapitalised banks to restructure if they have received state aid worth more than 2% of risk-weighted assets....

“There is no amount of capital that banks could reasonably hold that would insulate them from a break-up of the euro zone,” says one banker.