European Union leaders are under pressure from investors to devise a comprehensive plan to rescue the region’s banks before a Group of 20 summit in November.
“A blanket recapitalization of banks, in some cases, over- capitalizing those banks, would be the only thing that’s going to restore confidence at this juncture,” Simon Maughan, head of sales and distribution at MF Global Ltd. in London, said in a Bloomberg Television interview yesterday.
Plans to inject capital into Europe’s banks are “well under way,” European Commission President Jose Barroso said yesterday. The European Central Bank also reintroduced yearlong loans, giving banks unlimited access to cash through January 2013. Lenders in the region may need as much as 200 billion euros ($269 billion) of additional capital, according to the International Monetary Fund’s European head Antonio Borges.
Speculation that EU leaders may agree on a comprehensive recapitalization plan has helped to boost the 46-member Bloomberg Europe Banks and Financial Services Index 9 percent in the past two days. Bank stocks have dropped 30 percent this year as investors became increasingly concerned that financial firms will have to write down their holdings of Greek, Italian, Spanish and Portuguese government bonds.
Investors are also pushing up the cost of borrowing for those governments on concern that they will have to bail out their lenders. The challenge is for EU leaders to break that cycle before rising funding costs trigger a default by Greece or force banks to curtail lending and cause a recession.
No ‘Silver Bullet’
Even a recapitalization of European banks may fail to reassure investors because they will still question the ability of governments to meet their borrowing costs. Injecting capital into Europe’s banks won’t provide the “silver bullet” that is needed to solve the crisis, said Huw van Steenis, a banking analyst at Morgan Stanley in London. It needs to be done in conjunction with measures to shore up sovereign debt, he said.
“The banking crisis isn’t going to be resolved until the sovereign crisis is resolved,” said David Watts, a strategist at CreditSights Inc. in London. “Capital isn’t the way to go because the needs are too big and will weaken the sovereign.”
Banks would need to raise about 148 billion euros in the event of a 60 percent writedown on their holdings of Greek debt, 40 percent for Portugal and Ireland and 20 percent for Italy and Spain, Kian Abouhossein a JPMorgan Chase & Co. analyst, wrote in a note to clients Sept. 26. Deutsche Bank AG (DBK), Germany’s biggest lender, would need 9.7 billion euros more capital, Commerzbank AG (CBK) 5.1 billion euros and France’s Societe Generale (GLE) SA 6 billion euros, Abouhossein said.
Relying on ECB
European lenders are struggling to fund themselves and are reliant on emergency cash from the ECB. U.S. money-market funds cut their holdings of commercial paper sold by foreign financial firms, mostly European, by 31 percent in the third quarter, according to data compiled by Bloomberg. Lenders increased overnight deposits at the ECB yesterday to the highest in more than a year. Banks parked 221 billion euros at the ECB, the most since July 2010.
“The priority is to work hard and fast to prevent banks’ funding drying up, as this will only exacerbate funding difficulties for companies and consumers at a time when they are already under pressure due to the wilting recovery,” said Yael Selfin, head of macro consulting at PricewaterhouseCoopers in London. “The alternative could easily see the euro-zone economy going back into recession.”
‘Scaring the World’
Smarting from global criticism including U.S. President Barack Obama’s comment that Europe’s fiscal pain is “scaring the world,” EU leaders are looking at the November G-20 summit in Cannes as a deadline to show they are in control of events.
“They won’t want to go to Cannes without putting a plan in place to solve the euro zone’s problems,” Maughan said in an interview. EU leaders want to use the meeting to push through the Basel Committee on Banking Supervision’s latest round of capital requirements, he said. “That will be totally derailed if all that happens is that China, the U.S. and a whole number of other countries just lecture them on why they haven’t sorted their own problems out.”
EU leaders must still decide who provides additional capital to the banks and what form it will take. German Chancellor Angela Merkel said on Oct. 5 that Europe’s rescue fund should be relied upon only as a last resort.
“If a country cannot do it using its own resources and the stability of the euro as a whole is put at risk because the country has difficulties, then there’s the possibility of using the EFSF,” the European Financial Stability Facility, she said. Using the EFSF rescue fund is “always tied to a certain conditionality.”
German lawmakers last week approved an expansion of the rescue fund, setting the stage for the overhauled 440 billion- euro facility to be in place by mid-October. If approved by all 17 euro-zone countries, the fund will be able to provide money to governments, which could then inject it into their banks.
Policy makers are debating how to magnify the firepower of the EFSF to as much as 1 trillion euros. While one route would be for the facility to operate like a bank and borrow from the ECB, using bonds it purchases as collateral, Jean-Claude Trichet, president of the central bank, said yesterday that leverage wasn’t “appropriate.”
“The EFSF is simply not large enough to provide support to both troubled banks and troubled sovereigns,” said Sony Kapoor, managing director of London-based policy group Re-Define Europe. “Even after its upgrade, the EFSF won’t be able to support weak banks in troubled countries that are exactly the kind of institutions that most need its support.”
New Stress Tests
Southern European states are most likely to need money from the EFSF to recapitalize their banks, said Nick Firoozye, a senior rates strategist at Nomura Holdings Inc. in London.
“France and Germany can recapitalize their own banks, but it’s likely that Spain and Italy would need EFSF support to do so,” Firoozye said. “France and Germany are able to raise money in the bond markets at a cheaper rate than they can do through the EFSF. Europe needs to do the bank recapitalizations in a coordinated fashion to make sure they are effective.”
EU regulators’ stress tests on the region’s lenders in July failed to reassure investors that European banks will be adequately capitalized in the event of sovereign defaults. Eight banks failed the European Banking Authority’s tests, with a combined shortfall of 2.5 billion euros.
A new round of tests that require banks to maintain a minimum core Tier 1 capital ratio of 7 percent to 8 percent after writedowns on Greek, Italian, Irish, Spanish and Portuguese government debt would provide the trigger for further injections, Firoozye.
Still to be decided are the instruments individual governments will use to inject capital into their banks. Under one option being discussed, banks will issue preference shares to governments that would convert into core Tier 1 equity if a lender fails to reach a set capital target within a given timeframe, Morgan Stanley’s van Steenis wrote in a note. That would avoid immediate dilution of shareholders and allow lenders to raise capital when there is less stress in the markets, he said. Banks would be likely to face limits on compensation and dividends paid to investors until they repaid the government.
Also under consideration are mandatory convertible bonds, which would automatically convert into common equity on a set date; or contingent convertible bonds, which would convert into common equity if a bank’s capital levels drop below a predefined trigger, according to JPMorgan’s Abouhossein.
Edouard Carmignac, whose Paris-based Carmignac Gestion fund oversees about 40 billion euros, has called on the ECB to buy unlimited amounts of distressed countries’ sovereign debt. That would “relieve European banks of the more than problematic need for massive, immediate recapitalizations required by the depreciation of their sovereign debt holdings,” Carmignac wrote in a full-page advertisement in the Financial Times on Oct. 5.
“The intensity of policy debate has taken a step up, but it is a complex process and there is still a lot to be decided,” said Morgan Stanley’s van Steenis. “Odds are the recapitalization program is in November.”