Europe’s bank recap strategy has reached its limit

July 12, 2012

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Europe’s bank recapitalisation strategy has reached its limits. The continent’s lenders have added 94 billion euros to their capital buffers since the end of September, comfortably exceeding demands set by the European Banking Authority. Yet they are not yet in the clear. To restore trust, banks will have to clean up their loan books – and hope the euro zone can solve its sovereign woes.

Last autumn, the EBA calculated that Europe’s banks needed a combined 115 billion euros to hit a core Tier 1 capital ratio of 9 percent, after marking sovereign bonds to market prices. Greek lenders and bailed-out banks such as Belgium’s Dexia and Spain’s Bankia were subsequently excluded from the calculation. The remaining banks comfortably met the updated 76 billion euro shortfall by the end-June deadline.

Moreover, banks used relatively few tricks to hit their targets. Most of the improvements to capital came from banks issuing equity and convertible bonds; buying back hybrid debt at a discount; retaining earnings; or offloading assets. True, some banks tweaked risk models to reduce their risk-weighted assets, but this sleight of hand accounted for just 10 percent of the total capital raised. Concerns that banks would respond to the EBA’s demands by shrinking their balance sheets proved wide of the mark. Total loans contracted by just 0.62 percent.

But anyone who expects faith in Europe’s banks to be magically restored will be disappointed. Not only are funding markets largely closed to the continent’s lenders, many are dangerously dependent on the European Central Bank for liquidity.

Rebuilding confidence will require banks to clear out the bad assets still clogging up their balance sheets. And Spain’s bank bailout illustrates the extent to which domestic regulators have allowed lenders to keep their problem loans hidden from view.

Such a clean-up would clear the way for the creation of a pan-European banking union, backed by joint deposit insurance. That would help to break the toxic embrace between euro zone banks and governments. Ironically, responsibility for supervising such a banking union would probably rest with the ECB. In order to achieve its goal of restoring confidence in Europe’s banks, the EBA may have to accept a backseat role.

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