Banks hold billions of euros of sovereign debt on their books. In addition, the general quality of their assets has deteriorated in line with the macroeconomic outlook in Europe. If the sovereign debt crisis worsens or if bad loans begin to accumulate because of weaker growth, the risk of widespread impairments and losses on bank balance sheets rise.
Extra demand
As such, any step forward in the approach to dealing with the debt crisis has to include a plan to stabilise the European banking system. This is very likely to be in the form of higher regulatory capital requirements – perhaps over and above those prescribed in the Basel III accord.
What is not clear at the moment is who is going to provide the additional capital that regulators believe the banks need in order to prevent a systemic financial crisis.
There are some very complex models that attempt to estimate what the optimal level of capital is for a bank and the Basel III framework is essentially an estimate of the minimum capital requirement the banking industry as a whole should have given the regulators’ assessment of potential losses during economic downturns. However, there is no ‘right’ level for bank capital.
So as well as being close to a full-blown sovereign crisis we are also close to a major liquidity crisis in Europe. If there is a risk that, because of insufficient capital to cover losses, the bond investor might be asked to also shoulder some of the losses, then bank debt no longer becomes an attractive asset for a bond investor to hold.
Bond ownership
There has been virtually no bank debt issuance for some months, except in the form of covered bonds which investors appear comfortable with because they are backed by a pool of high quality assets. Banks have instead relied on a combination of pre-funding, de-leveraging and borrowing from the euro system central banks. The bank stress tests earlier this year did little to convince investors that banks have sufficient capital, or could easily raise it to cover potential losses.
Irrespective of what current bank capital levels are and the correct minimum capital ratio for the system as a whole is, the reality is that the market and policymakers think that Europe’s banks need more capital to provide a safety cushion against future potential losses. That need for additional capital – and the confidence it would bring – is evidenced by the inability of banks to fund at a cost that is economically viable. If increasing bank capital at the same time as the EFSF becomes operative and an orderly restructuring of Greek debt is achieved, then the funding markets may open up again and yields on bank debt may come down.
That, however, is a big “if”.
