Where is extra capital going to come from for UK or European banks?

The Bank of England's financial policy committee thinks that now would be a good time for banks to raise additional capital.

Setting aside my reservations about bank capital, where exactly is this capital going to come from?

As the Bank of England's Andy Haldane has said, banks are 'black boxes'.

Who is going to invest in a black box where they cannot assess the risk of the investment?

Since the beginning of the solvency crisis on August 9, 2007, I have been saying that in order to restore confidence, opacity must be eliminated throughout the financial system.

One place where there is considerable opacity is the black box that represents a bank.  To shine light into this box requires that the bank discloses its current asset, liability and off-balance sheet exposure details.

Without this data, it is simply impossible to assess the risk of a bank as the bank's exposures can and do change rapidly in today's financial markets.

Regulators confirm this fact every day by having bank examiners on-site at the largest financial institutions.

Nils Pratley has an interesting article in the Guardian focused on the question of where the capital is going to come from.

Alarm bells are ringing at full blast in Threadneedle Street. The current environment is "exceptionally threatening," says Sir Mervyn King. The spiral of decline - falling confidence, lower asset prices, tighter credit conditions, damage to the economy - is "characteristic of a systemic crisis." 

But what should banks do? On this score, the governor of the Bank of England offered only a broad description. The gist was: whatever it takes. 

The banks actually know that ultra transparency is required.  Notice how SocGen, BNP Paribas and Jefferies turned to it briefly when faced with bank runs.

So banks should raise their capital levels to preserve confidence and maintain lending capacity.

But how much capital is required? "There is no simple answer," said Sir Mervyn. In other words: just keeping jumping and don't stop to ask 'how high?'  

This advice comes with the usual qualification about the dangers of deleveraging: don't make matters worse by stopping lending to the economy. That implies cuts to bonuses and, possibly, straightforward capital-raisings since the Financial Policy Committee thinks bank boards should "give serious consideration to raising external capital in coming months." 

But how is the latter going to work? Take Royal Bank of Scotland, already 83% owned by the state. If wholesale funding markets become fully frozen (and ice has been forming since the spring), where should the bank turn? Are taxpayers meant to subscribe for a rights issue? Are we meant to nationalise RBS all over again? Is that where we are? 

It's not the governor's job to delve into specific mechanics of capital raisings - and, in theory at least, there are many sources of new capital before the buck lands on shareholders' laps. But the problem looks acute since, for three out of four UK banks, capital levels (as opposed to capital ratios, which can be improved by deleveraging) have been going down or sideways over the past year. 

And it gets worse. Hope is fading that a strong recovery in profits could raise capital levels. 

 "The outlook for UK banks' profits has deteriorated since the previous report [in June], particularly since the start of October, which would limit banks' ability to build capital without taking other actions," says the report. ... 

Two other points flow from the above. More capital implies lower returns on capital if other factors remain the same. So bank shareholders should probably prepare to kiss goodbye to the sunny thought that double-digit returns can be earned within a year or two. Most investors had already worked this out for themselves; it's only the bank managements that are clinging to the idea that 13% is in sight. 

But, since the banks may wish to cling to the hope that capital-raisings can be avoided, the Bank and Financial Services Authority may face a big battle to get their way on capital levels. 

Second, remember that the UK is not at the heart of this "exceptionally threatening" environment. The eye of the storm is the eurozone. And if UK banks need more capital, imagine the demands on eurozone lenders.

Europe's banks in free fall while regulators protect their information monopoly

The Independent ran an article describing how once again market participants are asking who is solvent and who is insolvent among Europe's banks.

Regular readers know that the reason that market participants have to ask these questions is the unwillingness of regulators to give up their information monopoly.

European regulators have effectively been gambling with financial stability by maintaining their monopoly and trying to substitute regulatory credibility and stress tests.  One year ago, the regulators ran stress tests and announced that virtually every bank tested had passed.  This included Irish banks that within two months had to be nationalized.

This year, the regulators ran stress tests and again announced that virtually every bank tested had passed.  Unlike last year, the regulators provided disclosure into the individual bank's exposures.  The idea being to let market participants to run their own stress tests.

Less than two months later, even with the benefit of some disclosure, the combination of regulatory credibility and stress tests has come up short.  Without full current asset and liability-level detail, market participants are still do not know who is solvent and who is insolvent.  As a result, inter-bank lending markets are freezing and stock investors are reacting to rumors.

Fear gripped Europe's banks yesterday as shares in French and Italian lenders dived on concerns they would be crippled by the eurozone crisis. 

Société Générale led French banks down as market rumours about its financial position sent its shares tumbling more than 20 per cent during the trading session. SocGen, France's second-biggest bank, was forced to issue a statement denying speculation that it was in trouble. 

Shares in Unicredit and Intesa, two of Italy's biggest banks, were suspended because of volatile trading. Fears about Italy's sovereign debt burden sent the banks down 9.4 per cent and 13.7 per cent respectively. 

French banks were hit by rumours that France was about to follow the US and lose its top AAA credit rating. SocGen shares closed down almost 15 per cent and have nearly halved in the last four weeks. BNP Paribas, France's biggest bank, fell 9.5 per cent. 

SocGen also suffered after a typographical error in a Reuters chart sparked concerns that the bank, a big bullion trader, was trying to raise cash by selling gold futures cheaper for 12 months than for one month. 

Later, rumours swept the market that an unlisted French insurer was in financial difficulty and had sold its big holding of SocGen shares. 

SocGen last week revealed a slump in second-quarter profit as the bank was hit by its big exposure to Greece. The bank also admitted it was unlikely to meet its 2012 profit forecast.
A SocGen spokesman said there had been no change since the profit warning, adding: "SocGen categorically denies all the market rumours." 

The eurozone crisis is in danger of spreading from peripheral countries such as Greece and Portugal to major economies such as Italy, Spain or even France. Fears about which banks might be hit by holdings of bonds issued by troubled countries have caused inter-bank lending costs to rocket. Simon Maughan, an analyst at MF Global, said: "Basically, the banks have stopped lending to each other again because of stories that one or another of them has gone under and that has created a liquidity problem." 

The situation is reminiscent of market turmoil following the bankruptcy of Lehman Brothers in September 2008, when plunging share prices and soaring costs of funding and debt sent the sector into meltdown. 

Last week the European Central Bank started to buy Italian and Spanish government bonds to stem the crisis but markets doubt its willingness or ability to do enough to stop the rot. 

Mr Maughan said central banks' attempts to ease fears were in fact "red flags" to the market. "All they have done is say, 'We are extremely concerned about the situation', and that has given an excuse for people to start selling." 

British banks were also casualties of the sell-off. Barclays dropped 8.7 per cent, followed by Standard Chartered and Royal Bank of Scotland, which both shed more than 7 per cent. Santander, Spain's biggest bank, fell 8.3 per cent. The US banking sector saw similar falls in early trading.

Standard Chartered confirms that lack of disclosure by banks is a direct contributor to bank runs

In case you missed it, a Telegraph article reported that Standard Chartered is practicing the modern day equivalent of a run on the Eurozone banks.  Their action publicly acknowledge the legitimacy of using the FDR Framework as a tool for risk management.

Bank runs occur when depositors and other investors no longer believe that the asset value of the bank exceeds its liabilities.

Please note, bank runs are based on the "fear" about the value of the bank's assets. If there was asset-level disclosure, the assets could be valued and banks, like Standard Chartered, could adjust their exposure based on facts.

Standard Chartered, the UK’s third-largest bank by market value, has made clear its fears of the likely fallout from the eurozone debt crisis by cutting back its lending to other European banks. 

Discussing the bank's first half performance, Richard Meddings, Standard Chartered's finance director, said lending to eurozone banks had been cut substantially due to concerns at the potential for contagion to the wider European banking system from the sovereign debt crisis. 

"We have been withdrawing liquidity from eurozone financial institutions and recycling it back into Asia," said Mr Meddings. 

Standard Chartered has no direct exposure to the sovereign debt of peripheral eurozone countries like Greece and Portugal, but Mr Meddings warned that the "dislocation" caused by a worsening in the crisis would hit all banks. 

Mr Meddings said there were likely to be "second order consequences" and that even banks with no holdings of the indebted countries' bonds could be hurt, though he added that Standard Chartered remained a net provider of funding to the interbank lending market.