Restructuring European banking systems

by Marco Onado

Vox
September 2, 2011

Growing pessimism and a spread of contagion is still haunting the Eurozone. This column argues that if the crisis moves beyond Greece, Ireland, and Portugal, no capital injection can reassure markets about possible losses on a few big Eurozone countries. What is needed is a credible restructuring of the debt of peripheral countries to ring-fence the damage.

IMF chief Christine Lagarde was correct; politicians are now focused mainly on European sovereign debt, but the banks are really the problem. In her Jackson Hole speech (Lagarde 2011), she said developed-country growth is throttled by the overhang of excessive debt. This means that large swaths of European banks’ assets are worthless. Lagarde is also correct in her finger-pointing. Politicians and national regulators are to blame. They have been dragging their feet and avoiding the radical responses needed to put an end to the crisis. But is she right in calling for more injections of capital into European banks?

Enough capital? For a default in the periphery, yes. But for one in the core, no

In my previous Vox column (Onado 2011), I argued that European banks’ capital is adequate to stand a significant reduction of the value of their claims on the 3 peripheral countries. Moreover, most banks have already marked-to-market their positions on these assets. In other words, the present level of bank capital is adequate to absorb losses limited to the 3 periphery countries.

After all, in the past months, European banks have increased their capital substantially, as the stress tests published in July have shown. According to a recent study (Citi 2011), the group of European banks covered by Citi has added over €270 billion of core capital since the end of 2008. Is it possible to go further than that? Is the amount of capital adequate to let the banking system face the storm?

The simple answer is: it depends. The higher the uncertainty, the higher the capital required – there is no limit to how much is enough if the uncertainty rises high enough. If bank capital is 5% of total assets, a 10% decrease in the value of banks’ assets is enough to expose creditors to losses. If bank capital is 10% of total assets, a 20% decrease in asset values puts the position underwater. Of course if the banks go under, the economy plummets, taking the banks’ asset values down with it. This is a paradox similar to the liquidity trap. Beyond a certain point, it is like crossing the “event horizon” of a black hole; uncertainty cannot be dissolved however strong the public intervention.

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