By SIMON NIXON / September 14, 2011
European banks are woefully short of capital to cope with multiple losses on euro-zone sovereign bonds. That was obvious long before Christine Lagarde, managing director of the International Monetary Fund, said so publicly in August.
It was clear from this year's European "stress test" disclosures, which showed a capital shortfall of €80 billion if Greek, Irish, Portuguese, Spanish and Italian debt had been marked to market prices. That deficit would rise to over €200 billion if the pass rate had been a 9% core Tier 1 capital ratio, Morgan Stanley estimates. That is similar to the initial IMF analysis.
But this only tells part of the story. Any losses arising from multiple restructurings of euro-zone sovereign debt are sure to go well beyond merely first order effects given the scale of interconnectivity. If the euro zone started to fall apart—perhaps as a result of an ECB refusal to keep funding Greek banks—the consequences would be incalculable as instant deposit flight led to a toppling of peripheral country banking systems. It is hard to see what scenario banks should be recapitalizing themselves to withstand, bearing in mind official euro zone policy is that there will be no sovereign defaults beyond Greece .
Besides, stock market valuations suggest markets are now focused on extreme scenarios. French bank shares have halved since the summer, yet they remain among Europe 's highest-rated banks even after Moody's downgraded Société Générale and Crédit Agricole Tuesday. BNP Paribas, which escaped a downgrade, is one of only six banks globally rated double-A after Moody's concluded it had capital to withstand severe haircuts on all peripheral government bond exposures and continues to generate capital. Its 13% return on equity in the first half of 2011 was the highest among globapeers. Yet BNP Paribas trades on 0.4 times book value. Société Générale and Crédit Agricole trade on 0.3 times.
For French banks—in common with all euro-zone banks—the real challenge is funding. Short-term dollar funding from U.S. money market funds is shrinking. But banks have plenty of access to short-term euro liquidity, including from the ECB, and can use foreign-exchange swaps to access dollars while they run down positions. BNP Paribas and Société Générale have said they will run down or sell U.S. dollar funded businesses.
The closure of medium and long-term bond funding markets is a potentially bigger challenge. French banks may have largely fulfilled their funding needs for 2011 but they all face heavy refinancing needs in 2012. If markets remain closed, they will be forced to deleverage even faster, threatening a credit crunch and feedback loops to the economy. But this merely underlines the need for the euro zone to come up with a comprehensive solution to its sovereign crisis. Until it does, bank investors are right to fear the worst.