Only one way out of EU banks' death spiral

A Bloomberg article looks at the death spiral that EU banks are in as a result of the financial regulators requiring them to hit a meaningless 9% Tier I capital ratio.

Regular readers know that I think the 9% Tier I capital ratio is flawed for a number of reasons.

First, it is a policy that is focused on the wrong issue at the wrong time.  Until all of the bad assets on and off a bank's balance sheet are properly valued, a bank's capital ratio is absolutely meaningless.  It is meaningless because both capital and assets are mis-stated.

Second, until banks provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, investors are simply not going to believe that all the losses have been recognized or be able to assess the risk of each bank.  What opaque structured finance securities taught investors is that if you cannot assess the risk of a 'black box' do not buy it.  Without ultra transparency banks are black boxes.

Third, with limited access to capital because of their opacity and regulatory policies like extend and pretend that hide their losses, the policy is contributing to a credit crunch for both businesses and sovereigns.  To achieve the 9% Tier I capital ratio, banks are shrinking and not increasing their balance sheets.  Shrinking of bank balance sheets would not be bad if new loans could be resold, but the largest buyer of these loans, the structured finance market, is incurring a buyers' strike until these securities also offer ultra transparency.

Fourth, achieving the 9% Tier I capital ratio appears to be raising, not decreasing, the Eurozone banks' risk profile.  As part of shrinking their assets, the banks have to sell their performing assets and crown jewels.  This leaves the non-performing assets on the balance sheet and a reduction of real earnings flowing through the income statement.  Not exactly the intended outcome.

Fifth, there is no evidence to suggest that a 9% Tier I capital ratio will restore market confidence particularly given the preceding four reasons.

European banks turning to their governments to raise required capital could trigger a downward spiral of declining sovereign-debt prices and further losses for the lenders. 

The European Banking Authority ordered the region’s banks on Dec. 8 to raise 115 billion euros ($154 billion) by June. Faced with dwindling profits and unable to tap capital markets to sell new shares, firms may be forced to seek government help. 

About 70 percent of the capital requirement falls on lenders in Spain, Greece, Italy and Portugal, countries struggling to convince the world they can pay their debts. 

“If the Southern governments put money in their banks, their sovereign debt will go up, exacerbating their problems,” said Karel Lannoo, chief executive officer of the Centre for European Policy Studies in Brussels. “Then the banks’ losses will rise because they hold the government debt. That’s a vicious cycle. It’s hard to know which one to stabilize first, the sovereign bonds or the banks.”...

Actually it is not hard to know which one to stabilize first.  Stabilize the sovereign first.  Banks can continue to operate with significant negative book capital so long as depositors believe in the deposit guarantee and central banks are willing to lend against good assets.

The new capital requirements followed stress tests by the EBA, which said it required lenders to mark all EU government bonds on their books to market values. Banks were asked to make up for the losses from declining prices with additional capital. 

While Greek banks have the biggest deficit and need to raise 30 billion euros, according to the EBA, they will get help from the EU and the International Monetary Fund. 

Spanish banks face the second-biggest bill, 26 billion euros. Banco Santander SA (SAN), the country’s biggest lender, was ordered to raise 15.3 billion euros, more than any other European bank. The company has said it plans to generate capital from profits and by changing internal calculations to assign lower risk to its assets. The EBA warned banks last week against manipulating risk-weightings to meet the requirements.

Spanish lenders also have 176 billion euros of loans and mortgages that soured after the nation’s housing market collapsed, the central bank estimates. Spain’s newly elected government, which takes power later this month, is considering setting up a bad bank to absorb those toxic assets. Capitalizing the banks to meet EBA requirements and shouldering the bad mortgages could raise Spain’s debt by as much as 20 percent of gross domestic product. It’s now more than 60 percent.... 

“The European banks (BEBANKS) can’t get fresh capital, so governments are going to have to cough up the money,” said Barbara Matthews, managing director of BCM International Regulatory Analytics LLC, a Washington-based consulting firm. “Germany is re-establishing its bank rescue fund, and it has the money to put in its banks. But when you look at public sources, you run into a problem. Do the other sovereigns have the cash to do it?”...

Because banks can’t raise capital from the market and some governments can’t afford to provide cash, compliance most likely will be through asset sales and reduced lending in the region, said Lannoo of the Centre for European Policy Studies. The EBA has told banks not to meet the new capital requirements through such measures, instead asking them to refrain from paying dividends.

European banks have already announced 1.2 trillion euros of asset sales as they try to reach a 9 percent capital ratio by June, according to data compiled by Nomura Holdings Inc. The shrinking of bank balance sheets in the region may reach 3 trillion euros, Barclays Plc (BARC) estimates. 

One European bank executive who requested anonymity because plans weren’t public said his company intended to comply with requirements of the stress tests by lending less in 2012. By giving the banks six months to comply, the EBA has provided a go-ahead for deleveraging, an EU official said, asking not to be identified to avoid interagency conflict. 

The EU leaders’ agreement for tougher budgetary discipline coupled with banks cutting lending will cause a “huge recession” in Europe, AEI’s Lachman said. The result of the stress tests will be constrained lending, especially in the Southern countries, which will make their economic rut even worse, Lannoo said. 

“North has fared well so far, but if the South derails further, then the North will trip too,” Lannoo said. 

The size of potential losses at European banks has scared away short-term creditors, squeezing the region’s lenders. The European Central Bank has stepped in to replace funds being withdrawn, providing unlimited cash and lowering requirements on the quality of collateral it will accept. 

“We’re in a death spiral,” said Andy Brough, a fund manager at Schroders Plc in London. “As the yields on the peripheral bonds increase, value of the bonds decreases and the amount of capital the bank has to raise increases.”