EU Banks Taking Government Cash Seen Sparking ‘Vicious Cycle’

European banks turning to their governments to raise required capital could trigger a downward spiral of declining sovereign-debt prices and further losses for the lenders.

The European Banking Authority ordered the region’s banks on Dec. 8 to raise 115 billion euros ($154 billion) by June. Faced with dwindling profits and unable to tap capital markets to sell new shares, firms may be forced to seek government help. About 70 percent of the capital requirement falls on lenders in Spain, Greece, Italy and Portugal, countries struggling to convince the world they can pay their debts.

“If the Southern governments put money in their banks, their sovereign debt will go up, exacerbating their problems,” said Karel Lannoo, chief executive officer of the Centre for European Policy Studies in Brussels. “Then the banks’ losses will rise because they hold the government debt. That’s a vicious cycle. It’s hard to know which one to stabilize first, the sovereign bonds or the banks.”

European Union leaders meeting in Brussels last week agreed to move toward a closer fiscal union, with harsher penalties for countries violating budgetary constraints. With the action, German Chancellor Angela Merkel and her counterparts aim to stem the erosion of confidence in the ability of some nations to pay their debts. Market reaction to the announcement was mixed, with stocks climbing and bonds falling.

Stress Tests

The new capital requirements followed stress tests by the EBA, which said it required lenders to mark all EU government bonds on their books to market values. Banks were asked to make up for the losses from declining prices with additional capital.

While Greek banks have the biggest deficit and need to raise 30 billion euros, according to the EBA, they will get help from the EU and the International Monetary Fund.

Spanish banks face the second-biggest bill, 26 billion euros. Banco Santander SA (SAN), the country’s biggest lender, was ordered to raise 15.3 billion euros, more than any other European bank. The company has said it plans to generate capital from profits and by changing internal calculations to assign lower risk to its assets. The EBA warned banks last week against manipulating risk-weightings to meet the requirements.

Spanish Debt

Spanish lenders also have 176 billion euros of loans and mortgages that soured after the nation’s housing market collapsed, the central bank estimates. Spain’s newly elected government, which takes power later this month, is considering setting up a bad bank to absorb those toxic assets. Capitalizing the banks to meet EBA requirements and shouldering the bad mortgages could raise Spain’s debt by as much as 20 percent of gross domestic product. It’s now more than 60 percent.

BNP Paribas SA (BNP), France’s largest lender, was asked to raise 1.5 billion euros after the stress test, while No. 2 Societe Generale (GLE) SA needs 2.1 billion euros. Moody’s Investors Service, which downgraded the ratings of both last week, said there’s a “very high” chance they’ll get state support if needed.

French banks have the means to recapitalize themselves without help from the government, Budget Minister Valerie Pecresse said yesterday. The EBA last week cut the amount that country’s banks need to raise by about 17 percent to 7.3 billion euros as it revised its figures based on September holdings after using June numbers in earlier estimates.

‘Cough Up’

Italy’s banking association said it will oppose new capital requirements set by the EBA “in every way” and is ready to take legal action, according to Italian news agency Ansa. The European regulator increased Italian banks’ requirement by 3.4 percent to 15.3 billion euros.

Ireland’s effort to back its banks brought the country to the verge of collapse last year. After issuing a blanket guarantee on all bank debt in 2008, the government was compelled to keep plugging holes as losses mounted. Sovereign debt doubled to more than 100 percent of GDP after about 60 billion euros were put into the nation’s lenders. Ireland sought a rescue package from the EU and the IMF in November 2010.

“The European banks (BEBANKS) can’t get fresh capital, so governments are going to have to cough up the money,” said Barbara Matthews, managing director of BCM International Regulatory Analytics LLC, a Washington-based consulting firm. “Germany is re-establishing its bank rescue fund, and it has the money to put in its banks. But when you look at public sources, you run into a problem. Do the other sovereigns have the cash to do it?”

Capital Holes

While strapped governments could turn to the European Financial Stability Facility for funds to put into their banks, the EFSF has struggled to expand beyond the 440 billion euros it has available.

“The EFSF doesn’t have enough money to support Italian and Spanish sovereign debt as well as put money into the European banks,” said Desmond Lachman, resident fellow at the American Enterprise Institute in Washington. “It just can’t do all of that.”

The EU banks’ capital holes are bigger than the EBA’s latest estimate, Lachman said, citing a September IMF estimate of a 300 billion-euro risk based on more favorable prices for government bonds at the time.

Because banks can’t raise capital from the market and some governments can’t afford to provide cash, compliance most likely will be through asset sales and reduced lending in the region, said Lannoo of the Centre for European Policy Studies. The EBA has told banks not to meet the new capital requirements through such measures, instead asking them to refrain from paying dividends.

Asset Sales

European banks have already announced 1.2 trillion euros of asset sales as they try to reach a 9 percent capital ratio by June, according to data compiled by Nomura Holdings Inc. The shrinking of bank balance sheets in the region may reach 3 trillion euros, Barclays Plc (BARC) estimates.

One European bank executive who requested anonymity because plans weren’t public said his company intended to comply with requirements of the stress tests by lending less in 2012. By giving the banks six months to comply, the EBA has provided a go-ahead for deleveraging, an EU official said, asking not to be identified to avoid interagency conflict.

The EU leaders’ agreement for tougher budgetary discipline coupled with banks cutting lending will cause a “huge recession” in Europe, AEI’s Lachman said. The result of the stress tests will be constrained lending, especially in the Southern countries, which will make their economic rut even worse, Lannoo said.

“North has fared well so far, but if the South derails further, then the North will trip too,” Lannoo said.

‘Death Spiral’

The size of potential losses at European banks has scared away short-term creditors, squeezing the region’s lenders. The European Central Bank has stepped in to replace funds being withdrawn, providing unlimited cash and lowering requirements on the quality of collateral it will accept.

“We’re in a death spiral,” said Andy Brough, a fund manager at Schroders Plc in London. “As the yields on the peripheral bonds increase, value of the bonds decreases and the amount of capital the bank has to raise increases.”

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net or @yalman_bn on Twitter

To contact the editor responsible for this story: David Scheer in New York at dscheer@bloomberg.net.

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