How much capital do European banks need?

Viral Acharya of NYU does a real good job of putting numbers to the hot financial problems. He is more like a market economist working in financial firms and not really a university.

In a recent article along with Dirk Schoenmaker and  Sascha Steffen he estimates the capital needed by European banks. Apart from this the trio also tells you why the recent measures by EU policymakers are just plain wrong.

First, why the recent measures to prop up banks are wrong?  EU policymakers said:

There is broad agreement on requiring a significantly higher capital ratio of 9 % of the highest quality capital and after accounting for market valuation of sovereign debt exposures, both as of 30 September 2011, to create a temporary buffer, which is justified by the exceptional circumstances. This quantitative capital target will have to be attained by 30
June 2012, based on plans agreed with national supervisors and coordinated by EBA.

Banks should first use private sources of capital, including through restructuring and conversion of debt to equity instruments. Banks should be subject to constraints regarding the distribution of dividends and bonus payments until the target has been attained. If necessary, national governments should provide support , and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries.

The authors say mentioning it as a ratio means equity/assets and ideally equity should be rising. Banks have instead preferred to lower assets leading to further deleveraging:

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.

Hmm. European policymaking at its best.. Anything they do there are some deep flaws..

They estimate the capital based on leverage ratio prescribed by Basel III norms:

Which banks have the full trust of markets and can thus finance themselves without any problem? Examples are well-capitalised banks such as HSBC, JP Morgan and Rabobank. These banks operate on a leverage ratio of about 6% (common equity/total assets). That is twice the new Basel leverage ratio of 3%. A less extreme benchmark would be to recapitalise banks well beyond the minimum of 3%. For illustrative purposes, we take an extra 33% above the buffer amounting to a leverage ratio of 4%.

Two scenarios are calculated for these benchmarks.

  1. Using BOOK value of equity and assets, the less stringent benchmark is a leverage ratio (Book Value of Equity/Total Assets) of 4% and the more stringent benchmark is a 6% ratio
  2. Using MARKET value of equity instead, the less stringent benchmark is a leverage ratio (Market Value of Equity/Total Assets) of 4% and the more stringent benchmark is a 6% ratio.

These tests were run on 84 banks.

  • Under first scenario these banks need Eur 189 bn at 4% leverage ratio and 605 bn at 6% LR.
  • Second scenario can only be calculated for listed banks which were 49. This requires EUR 443 bn under 4% LR and EUR 865 bn under 6% LR. This is because market value of banks is much lesser than face value as share prices have tanked.
The authors say they take a higher leverage ratio than Basel III norms as following Basel-III ratio of 3% leads to much lower need for capital which is not seen as credible:

We acknowledge that the indicated benchmarks are not based on existing regulation, but we present them as being informative about the required orders of magnitude if banks are to reach the levels of safety of those banks that seem to be regarded as properly capitalised by the markets.

The chosen benchmarks are inspired by the new Basel leverage ratio of 3%. To put our figures for required capital in perspective, we apply the 3% leverage ratio to the numbers on ‘book value of equity’/’total assets’. In the scenario of 3% leverage, 16 banks would have a shortfall amounting to only €27 billion. That illustrates that this regulatory benchmark does not succeed in instilling market confidence.

As clarified by Figure 2, using risk-weighted assets which attach zero risk weights to several sovereigns is not an appropriate benchmark. While imperfect, unweighted assets – as employed in the Basel leverage ratio – is, under the circumstances, far superior in our view to risk-weighted assets.

Dexia provides a good illustration of the deficiency of the risk-weighted approach. Dexia reports 10.4% on the Core Tier 1 capital ratio in July 2011. This is twice the minimum of 5% used as benchmark in the July 2011 stress test. On our leverage measure, Dexia scores 1.34% on ‘book value of equity’/’total assets’ and 0.49% on ‘market value of equity’/’total assets’. These figures are well below the future regulatory benchmark of 3% as well as our indicative benchmarks of 4% and 6%.

Another interesting thing is problems with CAR ratio which is based on risk weighted assets. As sovereign bonds are with zero risk, it just leads to an overestimation of capital in the banks and lower losses in the system. Once we make adjustments for this, the capital needed is much larger.
They add the capital should be preferably be raised from markets via deep discounted right shares. In case markets do not buy the share offers, governments should step in via EFSF etc.  Better to raise additional capital which can be returned if the profits are more.
Preferably, banks should raise the extra capital in the market. That can be done by a deeply discounted rights issue. Current shareholders have then the right to buy the newly issued shares. They will have an incentive to do so as the new shares are underpriced (deeply discounted). If they do not have the necessary cash, current shareholders can sell the new shares.
We trust that most European banks can refinance themselves in the private market, as the American banks did after the stress test in 2009. UniCredit has recently announced plans to raise €7.5 billion of fresh capital in the market.
It is important that the uncertainty about Eurozone sovereign debt is reduced. The approach to sovereign debt, however, is beyond the remit of our contribution. The aim of the recapitalisation is to ensure that European banks can absorb potential losses from sovereign-debt restructuring. If sovereign (and real estate) losses do not materialise, banks can return the extra capital to shareholders in dividend. The recapitalisation is thus a ‘no regret’ approach. If losses materialise, banks are better able to absorb them; if not, the capital may be returned.
Nice article. How this crisis is enfolding from a fin crisis to a sovereign debt crisis and back to banking crisis is quite a story. Overall huge capital needs of European banks ranging from EU 200 bn to EUR 800 bn..
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