EFSF, not bank capital, the key



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Michael Symonds, Credit Research
Daiwa Capital Markets Europe Limited
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27 October 2011

When compared with the rest of the package announced by euro area leaders last night, the proposals aimed at restoring confidence in the banking sector were fairly fully-formed, with target capital ratios and a timeline to achieve those both agreed. And while some important details still need to be worked out, by the middle of next year 70 euro area banks should all be significantly better capitalised than they currently are. But the announcement did little to change our view that the recapitalisations are largely irrelevant - perhaps even a further destabilising factor - if market participants don't consider that the broader plan has killed off concerns that the a wider euro area sovereign debt restructuring is on the cards.

The basic proposals on bank capital were largely in line with pre-summit leaks and speculation. Seventy of the EU’s largest banks will be expected to temporarily meet a “Basel 2.5” core tier 1 capital ratio of 9% after accounting for market valuation of sovereign debt exposures as of 30 September 2011. Banks will have until 30 June 2012 to address any shortfalls and will first be expected to raise any capital required from private sources, including hybrid debt to equity conversions, before calling on either national governments or, as a last resort, the European Financial Stability Facility. Where a capital shortfall is identified, the relevant bank will have until 25 December 2011 to present a plan detailing what actions it will take. The measures call for national supervisory authorities to ensure that banks' plans to strengthen capital do not lead to excess deleveraging. In practice, of course, it will be exceptionally difficult to prevent banks from going down this route.

While the below chart highlights the major capital shortfalls by country, it must be stressed that these are preliminary figures based on end-June 2011 balance sheets. The final capital shortfalls will be released in November based on end-September 2011 balance sheets. Nevertheless, even based on these preliminary country estimates individual banks and national authorities have gone on the offensive this morning. Banks have begun communicating their individual shortfalls and the remedial measures they intend to take. Unsurprisingly, most banks hope to boost their capital buffers without tapping existing shareholders and governments. While part of the capital raising could be achieved through earnings retention, there is little doubt that deleveraging will be the focus of management initiatives. Whatever, the race to get capital ratios higher is now underway in earnest.

Estimated capital shortfall by country

Source: European Banking Authority and Daiwa Capital Markets Europe Ltd.

It is also worth highlighting that, positively, measures to ensure medium-term funding of European banks are also now on the EU agenda (short-term funding is already ensured by the ECB and/or relevant national central banks). The EU governments recognised that guarantees on bank liabilities may be required to allow banks to access to longer-term funding. Of course, national government debt guarantees are no longer as powerful in some countries as they were in 2008. Therefore the proposals suggest than an approach at the EU-level will be considered. How this will be achieved in practice, however, is far from clear.

EU Banks: bonds issued and future maturities

Source: Dealogic and Daiwa Capital Markets Europe Ltd.

All told, the bank recapitalisation plan is by far the most worked out of the decisions taken yesterday, with a clear path now set out for (broadly) how much capital banks should raise, and by when. But whether or not markets believe that the Greek debt restructuring is the precursor of debt restructurings in Italy in particular is much more important in determining whether last night's summit brings an end to Europe's banking crisis. And with our economists doubtful that last night’s package will convince investors that policymakers are definitively on top of the sovereign debt crisis, even a 9% capital ratio may not prove sufficient to assuage investor’s concerns about euro area banks.

Michael Symonds
Credit Analyst

 

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