The Neutron Bomb of Capital Calculations

One obvious question is whether one should move to so extreme a scenario as provisioning against all sovereign debts, or even all European sovereign debt. Ever-expanding capital requirements can be the neutron bomb of banking
regulation; the branches might still be standing, but the banks themselves would be barely recognizable if they were to survive the cataclysm. Once the Germans understand that they too are exposed, they presumably will be amenable to more reasonable approaches to the sovereign debt problems, such as more generous volumes and maturities at collateral facilities or even a direct use of the ECB to support sovereigns so as to avoid crushing the banking system.
The cataclysm plays out because the banks do have an alternative to raising capital – shrink the balance sheet.

Deleveraging is already going on in a number of countries, with loan-to-deposit ratios dropping in recent months in Portugal, Spain, and Italy. This reduces the capital needs of banks, but fairly quickly starts to cut into the muscle of the financial system. The banks have little alternative but to keep holding sovereign debt in the short term, since it is the collateral for their borrowing needs. In countries such as Spain, a big chunk of private sector loans cannot be reduced because they involve property that will be inactive for years, perhaps a decade. So, once banks trim their healthiest borrowers and perhaps reduce their overseas exposures, they quickly run into the need to cut loans to small and medium enterprises, providing another negative impulse to European growth.
Perhaps more serious is the direct risk that Spain’s real estate problems pose to Spanish banks, which could expand to indirect risks for other banks. Recent conversations in Spain have led me to the conclusion that there are over 200 billion euros of property loans on raw land and developments, which will have little income-producing potential this decade.

While Spanish banks have done some provisioning, there is much more to do, and the losses will be high. The incoming Spanish government is rumored to be interested in accelerating this resolution through a good bank/bad bank solution.
A few of the banks could probably cover their capital needs through further asset sales, but most of the losses would probably have to be backstopped by capital infusions by the Spanish sovereign, temporarily raising its own deficit.
Conclusions


Recapitalization efforts by European banks are starting to gear up. Within the last few weeks, the Italian bank Unicredit has scheduled a new capital raising of 7.5 billion euros; Commerzbank of Germany has replaced preferred bonds
with equity; Spain’s BBVA has sold a mandatory convertible bond worth 3.5 billion euros to retail customers; and Spain’s Santander has sold a stake in its Chilean subsidiary, scheduled a group placement of holdings in the Brazilian
subsidiary, and announced a deal to sell 95% of its unlisted Colombian subsidiary. The family jewels are being sold.

I believe those deals are merely the beginning. The capital needs of European banks are large – in some scenarios dwarfing the 100 billion euros identified by the Europeans earlier this year even without incorporating the needs that might arise from a European or global recession. Spanish and Italian banks face the greatest needs, but there are plausible scenarios that would also generate large capital calls from French and German banks.
In any case, you can bank on it: European banks need tons of money.

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