Over the weekend, European leaders announced their intention to tackle the European banking crisis in the next few weeks.
The following chart, reproduced from an IMF report, indicates the need for urgent and decisive action for European banks. Although most banks in the developed world are optically well capitalized, in terms of capital adequacy ratios calculated using Basel norms, there are many unfounded assumptions and warranties in Basel calculations.
One of these unfounded warranties is that OECD sovereign debt is risk-free, and hence attracts zero risk weight. We at Decimal Point were always critical of this warranty issued by BIS. In the current juncture, this warranty is laughably out of context.
Another assumption in the Basel framework is that subordinated debt holders are willing and able to take losses due to unfavorable developments in the bank’s asset book. By looking at all the political maneuvering since 2008, it is clear that subordinated debt holders do not have any appetite to absorb losses and are willing to exert substantial political pressure on the banking and political system to avoid the impending losses.
Analyzing bank’s health using “Tangible Common Equity Ratio” dispenses with the above fallacies.
Another issue not addressed by the BIS is the quality of bank funding. If a bank is dependent on wholesale funding, the risk of a sudden bank run increases quite rapidly.
In the chart below we have plotted Tangible Common Equity and Wholesale Funding Ratio for banks in various developed countries.
From the chart it is clear that on book value basis, French and German Banks are leveraged around 50x their capital. In other words, a mere 2% adverse movement in asset values can make the banking systems insolvent in both the countries. Also, a fear of impending insolvency, combined with significant dependence on wholesale funding, has created immediate liquidity issues for the French banking system.
Moreover, it is interesting to note that many assets, such as bonds and equities in Europe have shown significant adverse price movements in the last few quarters. Hence, based on current market values, the Tangible common equity ratio for French and German banks could be significantly lower than 2%.
If French and German banks were to achieve Tangible common equity ratio of 6%, equivalent to the US banking system, these banks would require capital infusion of around 5% of assets. Since the
assets of French and German banks are significantly higher than their respective GDPs, the cost of this rescue could be between 7% to 10% of French and German GDPs. Moreover, this kind of rescue would virtually wipe out existing shareholders of most of the banks. And, even this rescue would not be sufficient to completely shield banks from any possible losses from Italian or Spanish sovereign write-off, if they were tooccur.
Considering the gravity of the situation, it becomes very critical that European leaders act very quickly and in decisive quantum.