Lagarde is right: European banks do need more capital

Well, European politicians who thought that by appointing Christine Lagarde as the head of the IMF European and the Eurozone would continue to have an easy ride received a ride shock this weekend. Not only did the reformed Lagarde say that European banks needed more capital, she also suggested that the EFSF or other pan European entity could be source of the funds (to gasps of horror in Berlin).   

European officials have been quick to dismiss these suggestions.

The Financial Times for the example reports this morning that Amadeu Altafaj-Tardio, spokesman for EU economic chief Olli Rehn, said the recently-completed stress tests for the banking sector showed that only a select group of banks were in need of capital injections and that national authorities were already dealing with those cases.

But the market prices of European banks have been market down, in some cases very sharply in recent week, signally skepticism over the value of the stress tests.  So let's look at some of the issues.

In the first case, we must remember that the European stress tests are designed to test whether the European banks have enough equity capital to protect the interests of the creditors. The stress tests are focused on the interests of creditors and have nothing to say about equity holders. If the risk of substantial loss to equity holders is high then obviously they should pay less for the equity even though the stress tests might suggests that creditors are likely to be safe.

In the second case, the European stress tests ignored the key issue facing asset values in Europe - which is the value of sovereign debt. These are assumed to have no default risk in the stress tests  - whereas the markets consider that the likelihood of a default by Greece, Portugal and Ireland is high. In recent weeks even Italian bonds have begun to discount some default risk. The stress tests are based on a ridiculous assumption.

The markets can look and should look at the quality of bank balance sheets in a different way: the amount of leverage should be measured and compared after all assets have been stated at their fair values (including sovereign debt which is trading below par) and all non-tangible assets should be written off. This includes goodwill arising on consolidation and deferred tax assets. Furthermore, all off balance sheets assets and liabilities should be brought on balance sheet and the adjustment made for differences between IFRS and US GAAP on the netting off of derivatives, setting off and off balance sheet items.

Only when this is done can we compare like with like. For the European banks we see the following values for the amount of equity held as a percentage of assets based on the latest available financial data, adjusted as described above:

Name	Equity Ratio		Tier 1
Dexia	-0.22%		13.4%
Deutsche Bank	1.12%		14.0%
UBS	1.18%		18.1%
CS	1.42%		18.2%
Santander	1.72%		10.4%
Credit Agricole	1.86%		10.5%
RBS	1.94%		13.5%
Barclays	2.13%		13.5%
Commerzbank	2.32%		11.6%
Unicredito	2.46%		9.9%
Lloyds	2.58%		11.6%
ING	2.69%		12.0%
HSBC	2.99%		12.2%
Natixis	3.32%		11.6%
Popolare	3.51%		7.9%
Soc Gen	3.57%		11.3%
MPS	3.74%		9.1%
BNP	3.82%		11.9%
BBVA	4.02%		9.8%
Raifessein	4.23%		9.7%
Intesa	4.42%		11.8%
Erste Bank	4.58%		10.5%
KBC	5.24%		12.6%
Standard Chartered	5.94%		13.9%
Sabadel	6.89%		9.8%
BPES	8.07%		9.8%

Note the wide disparity between the Tier 1 ratio and the equity ratio we have here. Note also that the Eurozone is by no means the worst in Europe: the British and Swiss figure prominently in the top half. But with the ability to issue their own currencies, the Swiss and British authorities could recapitalise the banks by printing money. Not so the Eurozone countries. Recapitalizing Eurozone banks is likely to be far more difficult. That's the problem.

 US banks are not significantly better capitalized on this basis: Bank of America has an equity ratio of 2.56% (the weakest among the major US banks) and at 4.94% JP Morgan is the strongest. Smaller US banks are all much stronger than these behemoths - CIT is a standout with an equity ratio of 21.6%.

So let's not pretend that the banks are rock sold.

UPDATE 31st August 2011

The Financial Times reports this evening that a fierce debate has broken out between the IMF and the EZ authorities over how to measure bank capitalisation. The EZ is objecting to the IMF's use of market based measures of asset value, such as CDS - as if the EZ knows better. The full article is here
(you've got to get through the FT's ridiculous firewall I am afraid)