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How much capital do European banks need? Some estimates

Wed, 23 Nov 2011 05:44:00 GMT

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The lack of market confidence in European banks is fed by the uncertainty about Eurozone sovereign debt. This column argues governments and banking supervisors should agree a recapitalisation package well before Christmas. It adds that the required amount to be raised by each bank should be presented as a euro amount and not as a ratio so as not to tempt banks to cut down assets instead of raising capital.

The European banking system is freezing up. Several banks are not able to fund themselves in the market. The lack of market confidence in European banks is fed by the ongoing uncertainty about Eurozone sovereign debt (as well as real estate) to which these banks are exposed.

At the recent October Summit, European leaders agreed on a recapitalisation package for European banks. Unfortunately, they specified required capital as a ratio (capital divided by risk-weighted assets) instead of a euro amount. As a result banks are now deleveraging instead of seeking fresh capital. A credit crunch is currently on its way. Moreover, the required recapitalisation falls short at what is needed to restore confidence.

We cannot afford a banking crisis with a detrimental impact on bank lending (real economy) and public finances (further rescues). A strong recapitalisation of the European banking system is crucial; the earlier October recapitalisation has not been decisive. Dealing with the banking system problems is a necessary condition for fostering European growth, but not a sufficient condition as the sovereign-debt problems also need to be addressed.

What would a good recapitalisation look like?

The purpose of an EU-wide recapitalisation of the banking system is to regain market confidence. The central idea is to recapitalise all European banks up to a high standard. On the one end, we can take the strongest banks (such as HSBC and Rabobank) that have the full trust of markets as benchmark. For this objective, an amount in the range of €500 billion would be needed. On the other end, we can take a benchmark that is well above the regulatory minimum. If we take an extra of say 33% over the minimum, we come to an amount in the range of €200 billion. The calculations are shown below. Well-capitalised banks will have full access to funding and will thus be able to satisfy the borrowing needs of governments, firms and households avoiding a credit crunch in Europe. The October recapitalisation package of €106 billion falls short of this range.

Preference for market solution

Preferably, banks should raise the extra capital in the market. That can be done by a deeply discounted rights issue. Current shareholders have then the right to buy the newly issued shares. They will have an incentive to do so as the new shares are underpriced (deeply discounted). If they do not have the necessary cash, current shareholders can sell the new shares.

We trust that most European banks can refinance themselves in the private market, as the American banks did after the stress test in 2009. UniCredit has recently announced plans to raise €7.5 billion of fresh capital in the market.

But fiscal backstop needed

For those banks that fail to raise the extra capital privately, there should be a fiscal backstop by the national governments. If necessary, governments could finance themselves from the EFSF. Governments should take an equity stake, so that they can also profit from the upside potential. As the shares are issued at a deep discount, governments will buy the shares below market prices. The October package provides for this fiscal backstop.

Read the Full Article over at VoxEU.

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