European bank recapitalisations could add to instability



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

Ahead of this weekend’s EU Heads of Governments summit expectations have been high – once again – that European politicians will finally deliver on their promise of a comprehensive plan to end the crisis. Last week our euro area economist surmised why a “bazooka” solution was unlikely, while comments from key protagonists in recent days, including Germany’s Finance Minister Schaeuble, should have served to somewhat dampen optimism over the outcome.

What we do know is that a key part of the planned offensive will be proposals to deliver a strengthening of European banks through recapitalisations. While we will need to wait at least until the summit concludes for the important final detail, there have been enough hints from involved parties to allow us to hypothesise with some confidence about how the bank recapitalisation process may proceed.

The proposals are expected to require the EU’s largest banks to hold a core capital ratio of at least 9% after accounting for impairments on their holdings of Greek government bonds and the marking-to-market of all other sovereign debt exposures. Of course, the move to apply prudent valuations to sovereign exposures represents a sensible improvement on the ineffectual EU-wide stress tests from earlier this year.

Banks are likely to be given six to nine months to address any shortfalls and will first be expected to raise any capital required from private sources, before calling on either national governments or, as a last resort, the European Financial Stability Facility.

We do not anticipate that broader stress tests (beyond sovereign exposures) will be undertaken and, therefore, believe that some market estimates for a total capital shortfall of up to €300bn are exaggerated. Our calculations suggest a figure closer to €100bn is the more likely outcome.

But whether the capital shortfall is €100bn or €300bn is largely irrelevant, given that the current banking crisis is merely a symptom of the fundamental lack of confidence in some euro area governments to be able to meet their debt obligations. And this dilemma cannot be resolved, even merely stabilised, unless euro area politicians deliver an incontrovertibly comprehensive plan to kill off concerns that the Greek tragedy is merely the precursor of a wider euro area sovereign debt restructuring.  As a minimum, this must incorporate the final resolution of the Greek bailout and a significant leveraging of the EFSF’s firepower sufficient to shield Italian and Spanish sovereign debt from the spreading contagion.

If this all-encompassing solution is not forthcoming, our lingering fear is that the bank recapitalisation process could actually end up adding to the current instability in the euro area. Not least because the progressive treatment of banks’ sovereign exposures would send a signal that euro area policymakers consider government debt haircuts outside of Greece now have to be treated as a realistic probability. They must, therefore, tread very carefully.

So, let us return to the scenario whereby the broader plan is less than comprehensive, as we expect, but the bank recapitalisation agenda is still pursued. With private investors sidelined by the unresolved sovereign crisis, banks will do absolutely everything possible to avoid public sector capital injections. Accordingly, they will first attempt to shrink their balance sheets in order to increase their capital ratios. If, as a result, lending was constrained further, economic growth in the euro area would slow even more sharply than already anticipated – hitting bank balance sheets through increased loan losses, but also adding to the pressure on government budgets.

But ultimately, banks will not be able to deleverage fast enough in the current environment and will have to turn to euro area governments for capital, with corresponding increases in debt-to-GDP ratios placing further pressure on already shaky fiscal positions. The inexorable transmission of risks from sovereigns to banks and back again would continue. 

At a time when French government 10 year spreads to bunds are at euro area record levels, the risk is that the weekend’s summit could ultimately accelerate, not stop, contagion in the euro area.

 

Michael Symonds
Credit Analyst

 

 

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