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Stress relief

18 October 2011 By Peter Thal Larsen

Bailing out Europe’s banks may be less expensive than governments feared – and investors hoped. European Union officials are discussing a plan that would require lenders to hit a demanding core Tier 1 capital ratio of 9 percent, but not factor in the effects of a deep recession. A lower-than-expected bill is good for euro zone governments’ finances – but may not be enough to win back the market’s confidence.

Europe’s latest recap is not a stress test like July’s, in which the European Banking Authority asked the continent’s largest 90 lenders to reach a minimum core Tier 1 capital ratio of 5 percent after a severe economic downturn.

The latest effort involves no such doomsday planning: the capital calculation is simply based on banks’ balance sheets at the end of June. Many lenders will be at or close to 9 percent already: according to EBA data, the 90 banks that participated in the summer’s tests had a combined, unstressed core Tier 1 ratio of 8.4 percent at the end of 2010. Since then, some have raised fresh capital, while most have boosted their buffers with retained earnings.

True, banks are not escaping entirely. Lenders with large exposures to troubled sovereign debt may have to hold an extra capital buffer. This could be substantial: if the sovereign debt disclosed in July’s stress tests were marked to current market prices, banks would have to write off almost 80 billion euros, according to Breakingviews calculations.

Even then, however, the total capital shortfall might be no more than 100 billion euros, according to Morgan Stanley – less than half most analysts’ estimates. That’s good news for euro zone governments, which are expected to finance most of the capital injections. But investors may be less impressed. For one, they have been primed to expect a larger recap. And while haircuts on sovereign debt are welcome, banks will also suffer losses on private sector loans in peripheral euro zone economies.

An added concern is that banks will be given up to nine months to hit the new target. That will encourage them to achieve the capital target by shrinking their balance sheets, possibly triggering a credit crunch. In that case, any relief from Europe’s bank recap would be short-lived.


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