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The Basel III global regulatory framework will require banks to meet enhanced capital adequacy standards gradually by 2019. Europe cannot wait that long. Waiting seven years to address the banking system’s weaknesses runs the risk of seven more years of weak growth.
The authors propose that the biggest eurozone banks should be required to meet Basel III capital standards by the end of 2013, following a rigorous and credible validation of their balance sheets. To ensure credibility, the ECB should lead this validation. Banks should be required to increase their capital ratios primarily by increasing equity – not by reducing credit and so deepening the crisis.
While this validation process is under way, the eurozone must act to limit market uncertainty about the ultimate fate of its most significant banks. Governments can do this by committing to provide public capital to the extent that these banks are deemed to need additional financing and are unable to raise private capital to meet the new standards. Such an approach worked in the US.
In 2009, the US government assessed the balance sheets of the nation’s 19 largest banks and set robust capital requirements for each. The US Treasury pledged that any bank that did not raise sufficient private capital would instead receive the capital via investments by the US government. Each bank was able to meet the new standards entirely from private sources. This marked the beginning of the end of the US banking crisis.
By pledging to purchase equity in their major banks at a price based on a discount to today’s market, eurozone governments would set a floor under the capital raise. This would give private investors the confidence to invest. Setting this floor at a significant discount to market prices would be fair to taxpayers and provide strong incentives for the banks to achieve the required capital levels through the markets rather than relying on government infusions. To the extent that an individual country is unable to provide a credible backstop, it would be extended through the European Stability Mechanism.
Any ECB bond purchase programme for a specific country would also be contingent on that country committing to the bank recapitalisation plan. To attract private capital, a consolidation of the banking sector will probably have to occur in those markets that have too many unviable banks.
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