Banks’ escape won’t solve capital woes

September 29, 2009

One by one, Europe’s banks are trying to wriggle free from state control. BNP Paribas is the latest escapee, with a plan to replace government-owned preference shares with common equity raised from shareholders. Judging by the market’s reaction, it is unlikely to be the last.

But the upbeat mood obscures the uncomfortable fact that banks have so far done precious little to expand their capital buffers.

Escaping government ownership has its benefits. By repaying 5.1 billion euros of preference shares issued by the government this spring, BNP Paribas avoids rising dividend payments and increasingly punitive terms on redeeming the preferred shares.

Earnings per share next year are enhanced by 8.4 percent. Less tangible, but equally important, is that the bank is no longer constrained from paying dividends and making acquisitions. Despite enlarging its share capital by a tenth at a 30 percent discount to the market price, BNP Paribas shares jumped 3 percent. 

Others are bound to follow suit. Unicredit is widely expected to raise equity from shareholders rather than accept capital offered by the Italian government. In the United Kingdom, Lloyds Banking Group and Royal Bank of Scotland are both contemplating rights issues in an effort to minimise state control. The new chief executive of UBS is talking about buying back bad assets the bank offloaded to the state last autumn.

Taxpayers who have pumped hundreds of billions into their banks will no doubt welcome the early return of their cash. This flurry of activity, however, is merely replacing one type of capital with another. It does not address the more fundamental problem, which is the banking system’s chronic lack of reserves.

Indeed, BNP Paribas’s Tier One capital ratio will be marginally lower after its manoeuvre than it was before. At a time when regulators are seeking to force banks to increase their reserves, this seems perverse. The danger for the broader economy is that banks will respond by further reining in their lending.

BNP Paribas will no doubt argue that its healthy profits enable it to rebuild capital quickly. The rights issue also allows it to replace preference shares, which cannot absorb losses on an ongoing basis, with common equity, which can.

Europe’s banks have issued equity worth more than $50 billion this year, on top of $93 billion last year, according to Thomson Reuters data. But this has largely been used to fill the hole left by large losses.

Now it is being used to repay governments. The need to strengthen balance sheets remains, however. There will be no shortage of banks looking to raise equity in the coming years. Those institutions that have escaped the state must hope investors do not lose their appetite.

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