22 November 2011

Schoenmaker et al: How much capital do European banks need? Some estimates

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.

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 per cent over the minimum, we come to an amount in the range of €200 billion. 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.

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.

Legal challenges

A government-imposed recapitalisation raises several legal issues that need to be addressed. First, can the government use funds in the required magnitude for this purpose? Second, is there a legal basis for the government to impose the proposed recapitalisation, which goes beyond the regulatory minimum? The first component is mainly political and can be handled by new legislation. The second component interferes with the protection of private property. However, lack of sufficient legislation should not stand in the way of averting systemic risks. There are many laws interfering with private property in order to protect the community from externalities.

How much is needed and when?

The aim is to restore market confidence in European banks now. So, the capital shortfall should be raised over a short time span. Banks could get, say, one month to raise the required amount privately. If they fail to do so, the fiscal backstop is provided (for instance, using the EFSF). There will be no choice for banks; the regulators have to force all banks with a projected shortfall to recapitalise. We acknowledge the difficulties of dealing with the fiscal-banking interdependence (recapitalising banks would worsen the fiscal position). A solution for this problem needs to be found. One possibility is to grant governments in need financial assistance from the EFSF. The current deadline of end June 2012 is far too long in the future. Governments and banking supervisors are advised to get the required capital in place well before Christmas.

Next, the required amount to be raised by each bank should be presented as a euro amount and not as a ratio. Banks have to raise that amount to keep up their lending (the ultimate aim of the recapitalisation). When presented as a ratio, banks may be tempted to cutting down assets instead of raising capital. On this measure, the October recapitalisation package has been wrong.

By presenting the recapitalisation as a ratio (capital is 9 per cent of risk-weighted-assets) and extending the deadline till mid-2012, banks have ample opportunity to deleverage. We see that now happening in practice (in particular Southern European bonds are offloaded). The European Banking Authority attempted to present a euro amount by applying the 9 per cent capital ratio to the 30 September 2011positions. That amounts to the capital shortfall of €106 billion. Instead of requiring the banks to seek fresh capital of €106 billion before Christmas, the European Banking Authority allows banks to deleverage until June 2012 in order to meet the 9 per cent capital ratio.

The European Banking Authority acknowledges that the level of recapitalisation they require is insufficient to fully restore market confidence. As banks need to refinance a substantial amount of debt in 2012, they suggest a public guarantee scheme to revitalise the term funding market. Public guarantee schemes were indeed many times over the size of capital injections during the 2007–09 financial crisis. Our estimates of the shortfall would in this case be relevant to understand the implicit burden being taken on by sovereigns while providing such guarantee schemes.

Finally, raising system-wide capital may expand values beyond what is attempted to be created, but one cannot rely on this positive externality. That would be a bonus. Moreover, recapitalisation increases the amount of equity and thus decreases the amount of debt in the banking system. Mounting debt levels (banks and sovereign) are at the heart of the current crisis.

Authors: Viral Acharya, Dirk Schoenmaker, Sascha Steffen

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