European banks face €400 billion capital shortfall, weighed down by France and Germany

It’s rare that a day passes without Euromoney hearing pangs of dissatisfaction among European bank analysts or would-be investors about the sorry state of the regional banking system, despite protestations to the contrary from public officials. A chief gripe is the extent to which European banks have refused to acknowledge their losses and write down bad loans, echoing the comedy of errors that has blighted Japan in recent decades.

As we reported last year, and as Ned Davis Research points out, the European Banking Authority’s (EBA) financial stress test in June 2011 – which determined the capital-raising target for the regional banking system for 2012 – was based on an excessively benign treatment of the coverage ratio. 

The median coverage ratio of the 90 European banks examined in the test was just 38% to meet the 9% core tier 1 capital ratio target. By contrast, the coverage ratio -  which indicates the amount of reserves banks have set aside relative to a pool of non-performing loans - for US banks equated to 67% in the first quarter of 2011, according to the Federal Deposit Insurance Corporation. In other words, at the time of the European banking stress test and regional recession, US banks had a coverage ratio three-quarters higher than for European banks.

This benign EBA-backed coverage ratio strengthened the market narrative that the European banking system – held down by bad debts – remains the “giant Damocles sword threatening the global recovery” amid policymakers’ intransigence, concludes Vincent Deluard, European analyst at Ned Davis Research.

In a November report, before the Draghi ‘put’, Deluard noted: “In its mild form, European banks’ refusal to recognize losses could lead to a Japanese ‘lost decade’: banks evergreen their loans [ie, rolling over loans to borrowers who are unable to pay], regulators agree to play the ‘extend and pretend’ game, and the credit creation mechanism is permanently clogged.

“In its severe form, evergreening could lead to a banking collapse. Investors or depositors call the bluff of European banks, funding markets dry up and banks have no choice but to admit their bankruptcy.”

ECB put

Although monumental ECB support has helped to downplay systemic risks for now – with the pace of capital outflows from the periphery banks slowing down substantially during the past two months – the market seems to view European banks’ capital positions with scepticism, judging by the fact most banks’ stock prices still trade at a discount to their respective book values.

On Thursday, the OECD, headed by Angel Gurria, added to the chorus of criticism – in contrast to the EBA’s upbeat assessments – by stating that the ratio of core tier 1 capital to unweighted assets of eurozone banks falls well short of 5% “in many cases”. On this benchmark, European banks face a €400 billion capital shortfall, or 4.5% of the eurozone’s GDP. It added: “This is not just a problem for banks in the ‘periphery’ – there could be large capital needs in the major euro-area countries. Future capital needs could be lessened if banks were required to separate commercial banking and market activities, reducing the total assets of the banking business.”

In comments that echo the IMF’s warnings but are likely to ignite the ire of eurozone policymakers, the OECD’s conclusion sounds like it was lifted from a eurogroup communiqué in 2009 – before the spate of capital-raising and restructurings in the eurozone ex-periphery: “Moving towards a stronger banking system would help to rebuild confidence and get credit flowing again.”

The OECD’s assessment unites the concerns of the Bank of England and the Basel Committee: banks have inflated their asset values, despite the EBA’s self-congratulatory claim in July 2012 that banks in the region had reached a minimum 9% of the best quality core tier 1 capital to risk-weighted assets, in excess of the current international requirements.

The OECD explains why this benchmark has failed to boost market confidence: “In part, this is because it is based on risk-weighting of assets that likely understates risks, due to reliance on banks’ own internal risk models and, for example, the zero risk-weight given to sovereign debt.”

While European banks have made progress in hiking their capital and deposit base, the true value of assets on their books remains one of the most contentious issues for crisis-torn Spain and Greece as well as for the core, principally, France and Germany. In fact, this OECD chart lays bare the risk that Europe's hidden banking crisis in France and Germany, in absolute capital terms, is far bigger than the bank-capital shortfall in Spain.