Eurozone banks have been aggressively deleveraging over the last year, shrinking by €2.9 trillion since May 2012, but they will need to shed another €3.2 trillion before the European financial sector is healthy, according to Alberto Gallo, Shikhar Sethi, and Lee Tyrrell-Hendry at RBS Macro Credit Research.

Eurozone Banks

Eurozone banks valuation

Eurozone banks are still valued at €32 trillion, more than three times the size of the entire Eurozone economy. Large banks will need to cut €661 billion in assets and raise €47 billion in capital, while small to mid-sized institutions need to drop €2.6 trillion in assets collectively, Gallo estimates.

Some large banks will be able to accumulate capital through profits, but others have too much ground to make up and will not be able to avoid further deleveraging. “Deutsche Bank AG (NYSE:DB) (ETR:DBK), Credit Agricole SA (EPA:ACA) (OTCMKTS:CRARY), and Barclays PLC (NYSE:BCS) (LON:BARC) need the most capital,” writes Gallo. “These banks show the highest shortfalls in our analysis, consistent with recent analysis.”

Deutsche Bank to reduce its assests

Deutsche Bank AG (NYSE:DB) (ETR:DBK) has already said that it will reduce its assets by 20 percent in the next few years and Barclays PLC (NYSE:BCS) (LON:BARC) wants to reduce its exposure by as much as £80 billion by the end of the second quarter next year. Societe Generale SA (ADR) (OTCMKTS:SCGLY) (EPA:GLE) and Commerzbank AG (ADR) (OTCMKTS:CRZBY) (FRA:CBK) (ETR:CBK) also need to get rid of some of their assets.

Meanwhile banks on the periphery have actually led the Eurozone’s deleveraging efforts, with Spain and Portugal doing more to get rid of bad assets than anyone else. Core Eurozone banks as a group are actually becoming more leveraged, despite the potential problems this could cause. New regulations will come into effect next year when the new banking union comes into effect, and Eurozone banks will have to meet new capitalization requirements.

Eurozone Banks spain portugal deleverage most Eurozone banks periphery banks deleverage

Concerns for banks in Spain and Germany

Part of this is unavoidable, as banks in the periphery have little choice but to deleverage or go under, while “national champions have plenty of earning capacity and liquidity and do not need to delever quickly,” writes Gallo. There is greater concern about what will happen to banks in Spain than in Germany, for example, but none of this changes the fact that the entire financial sector will have to scale down so that it doesn’t threaten to further destabilize the European economy as it has done these last few years.