EU Banks’ Capital Deficit Means Greek Default Not an Option

EU Banks’ Capital Deficit Means Greek Default Not an Option
A demonstrator waves a Greek flag with ''for sale'' notices on it during a protest outside the Greek parliament. Photographer: Aris Messinis/AFP/Getty Images

A failure by European regulators to make banks raise enough capital to withstand a sovereign default is complicating efforts to resolve Greece’s debt crisis.

The “fragilities” of Europe’s banking industry mean a Greek default isn’t an option, European Union Economic and Monetary Affairs Commissioner Olli Rehn said in New York last week. By delaying a decision some investors consider inevitable, policy makers risk increasing the cost to European taxpayers and prolonging Greece’s economic pain.

“European officials are trying to buy time for the troubled economies to get their house in order and the banks to be strengthened,” said Guy de Blonay, who helps manage about $41 billion at Jupiter Asset Management Ltd. in London.

While estimates of the capital shortfall vary, the vulnerability of European banks to a sovereign shock isn’t disputed. Independent Credit View, a Swiss rating company that predicted Ireland’s banks would need another bailout last year, found in a study to be published tomorrow that 33 of Europe’s biggest banks would need $347 billion of additional capital by the end of 2012 to boost their tangible common equity to 10 percent, even before any sovereign default.

European banks had $188 billion at risk from the government debt of Greece, Ireland, Portugal and Spain at the end of 2010, according to a report this week from the Bank for International Settlements. European lenders held $52.3 billion in Greek sovereign debt, with German banks owning the biggest share, the BIS data showed.

‘Voluntary’ Role

A year after the rescue that aimed to stop the spread of the debt crisis, Greece remains mired in recession, shut out of financial markets and saddled with Europe’s biggest debt load in proportion to its economy. Moody’s Investors Service said June 1 that it sees a 50 percent chance of a Greek default. In a Bloomberg survey last month, 85 percent of international investors said Greece will probably default.

European officials are preparing a new aid package for Greece that includes a “voluntary” role for investors after the EU and the International Monetary Fund approved the fifth installment of Greece’s 110 billion-euro ($160 billion) bailout last week.

Policy makers in Europe have been debating how to let private investors, including banks, join Greece’s bailout without triggering a default. One option they’re considering is asking investors to reinvest in new debt when existing bonds mature, Rehn, 49, said last week.

‘Kicking the Can’

Jean-Claude Juncker, 56, who leads a group of euro-area finance ministers, floated the idea last month of a “soft restructuring,” under which maturities of existing debt would be extended. European Central Bank policy makers including Bank of France Governor Christian Noyer have opposed that approach, and Moody’s and Fitch Ratings said they would probably consider it a default.

“They are kicking the can down the road,” said Adrian Foster, head of financial market research for Asia at Dutch bank Rabobank Groep NV in a Bloomberg Television interview on June 3. “Politically, it’s not too attractive to be bailing out the banks again should Greece default.”

ECB President Jean-Claude Trichet yesterday gave his first signal endorsing measures to encourage investors to buy new Greek bonds to replace maturing securities. While Trichet said he’s against imposing losses on creditors, he indicated he’d approve of financial institutions maintaining their level of outstanding credit. “That is not a default,” he said at an event in Montreal late yesterday. “That is something the ECB would consider appropriate.”

Bank Stocks Decline

Concern that European lenders lack the reserves to weather losses on an estimated $136 billion in foreign claims on Greece’s government, banks and companies led Laurence D. Fink, chief executive officer of BlackRock Inc., the world’s largest money manager, to say on May 31 that Europe is going to need a “giant TARP,” referring to the Troubled Asset Relief Program that the U.S. introduced to rescue financial firms.

The 51-company Stoxx 600 Banks Index was the third-worst performing group in the broader Stoxx 600 Index in the past three months, falling 10 percent amid concern that policy makers’ response to Greece’s debt crisis will have repercussions for Ireland and Portugal, which also got bailouts from the EU and IMF.

European banks are trading at 0.83 times book value, according to the banks index, almost the widest discount since the end of 2008 to their U.S. counterparts, which trade at 0.94 times book, based on the 24-member KBW Bank Index. The five-year average price-to-book ratio of the 51 European lenders is 1.34, data compiled by Bloomberg show.

‘Proper Return’

That banks in both regions are trading below book value indicates investors don’t believe their assets are worth as much as the companies say.

Low market valuations make any potential capital-raising more dilutive for shareholders, said Simon Maughan, head of sales and distribution at MF Global Ltd. in London. Questions about regulatory requirements are adding pressure on bank stocks, making a quick recovery unlikely, he said.

“The big issue behind why price-to-book ratios are well below averages is that the market is saying banks can’t make a proper return and certainly not a return anything like they’ve been used to getting,” said Maughan.

Higher Costs

Higher costs related to regulatory changes and slower economic growth in the region make it difficult for European lenders to increase revenue, Deutsche Bank AG CEO Josef Ackermann said in a speech June 1. Higher government funding costs also make it more expensive for a nation’s banks to borrow, he said.

“It comes as no surprise that most banks are currently trading close to their book value and that forecasts for future profitability in the sector have been cautious,” said Ackermann, 63. “Because they tend to have lower profitability, they also struggle more to build new capital organically as well as raise fresh capital.”

Deutsche Bank, Germany’s largest lender, had net sovereign risks tied to Greece of 1.6 billion euros at the end of last year, the Frankfurt-based bank said in March.

Stress Tests

EU regulators are seeking to assuage investors’ concerns about capital with a second round of stress tests on 90 lenders. The European Banking Authority is promising tougher tests this year after failing seven of 91 banks last year and finding a capital shortfall totaling 3.5 billion euros, or about a 10th of the smallest estimate from analysts. Ireland’s biggest banks needed a rescue four months after passing the test.

Tests carried out in the U.S. in 2009 found 10 lenders including Bank of America Corp. and Citigroup Inc. needed to raise $74.6 billion of capital. The banks were required to raise the funds from private investors or accept government aid.

In Europe, “the test will probably still turn out to be relatively lax,” said Christian Fischer, a partner and banking analyst at Zurich-based Independent Credit View. The rating company picked a 10 percent tangible-common-equity threshold because it’s about 30 percent above average ratio for the past 10 years. Tangible common equity excludes hybrid debt, goodwill and preferred shares from Tier 1 capital.

Goldman Survey

The EBA said on its website earlier this year that under the stress-test scenarios banks will be expected to maintain a core Tier 1 capital ratio of at least 5 percent.

A survey released yesterday by Goldman Sachs Group Inc. showed that 22 percent of 113 financial-industry respondents expected the results to provide a “credible reflection” of banks’ resilience, down from 35 percent before last year’s exams. On average, respondents estimated the tests will find that banks need to raise 29 billion euros of capital, Goldman Sachs said, with lenders in Spain, Germany and Greece needing the most.

Banks that fail the tests will have until the end of the year to complete plans to recapitalize or restructure their business, said Andrea Enria, chairman of the EBA, in an April interview. While the EBA will test for declines in sovereign bond values, it won’t include a default in its stress scenario.

The publication of the results, scheduled for this month, may be delayed until July after the lenders were asked to submit more information, an EBA official said June 1.

International central bankers and supervisors meeting in Basel, Switzerland, have decided that banks need to hold more capital to avoid future taxpayer-funded bailouts. The Federal Reserve supports a proposal at the Basel Committee on Banking Supervision that calls for a maximum capital surcharge of 3 percentage points on the largest global banks, according to a person familiar with the discussions.

Buying Opportunity

Independent Credit View conducted its own stress tests on 63 banks worldwide, assessing their capital needs by the end of next year after applying assumptions for loan-loss provisions, earnings growth and an increase in risk-weighted assets and liquidity requirements as a result of stricter regulation.

Banks in Portugal, Italy, Ireland, Greece and Spain had the highest capital deficits, and would need to raise $154 billion, or 67 percent of their market valuation, to boost tangible common-equity ratios to 10 percent from 9.1 percent at the end of 2010, according to the study.

The estimated capital shortage at 33 European banks amounts to 29 percent of their combined valuation, compared with 20 percent for the North American banks analyzed, according to Independent Credit View’s report.

Last Resort

For Dirk Hoffmann-Becking at Sanford C. Bernstein in London, the impact of a Greek debt restructuring is “seriously overstated,” making it a good time to buy banking shares.

“For the first time in nearly three years we are seriously bullish on European banks,” he wrote in a May 27 note.

Citigroup raised European banks to “overweight” the same day, citing the share drop as an opportunity to increase holdings in “stronger” companies such as London-based Standard Chartered Plc and HSBC Holdings Plc, Credit Suisse Group AG of Zurich, Paris-based BNP Paribas SA and DnB NOR ASA in Oslo.

Lorenzo Bini Smaghi, an ECB executive board member, was less sanguine in comments yesterday, saying a sovereign debt restructuring, in which bondholders would take losses, should be an option of “last resort” because it may have “severe implications” on the country and investors.

“More often than not, restructurings have been disorderly, harmful and fraught with difficulties,” Bini Smaghi said at an event in Berlin.


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