Governments and regulatory authorities have been reluctant to endeavor bank restructuring, because the aggregated total of bank assets are outsized compared to GDP. The European model of universal banking involves a commitment from banks in financing the economy much larger than in the US and Japan. Furthermore European banks are so closely intermeshed with cross border assets and liabilities, that bank failure has been thought as impossible. Worse, supervisory authorities have developed an attitude of denial of the moral hazard created by the “too-big-to-fail” argument and of the conflicts of interests inherent in diversified financial conglomerates.

Hurt by the 2008 financial crisis, European banks still absorbed the bulk of public debt expansion triggered by the multiple sources of public expenditures in 2009-10: discretionary expenditures of the stimulating plans, automatic stabilizers due to the recession and rescue to banks which were partly straight expenditures. To finance the surge in expenditures, governments issued large amounts of bonds. Borrowing from the ECB at a very low interest rate, banks bought hundreds of billions of Euros in sovereign bonds, hoping that they were piling up riskless profits. They thought there was no need to use these profits to foster their capital base and no supervisor told them to do so, though undetermined amounts of bad legacy assets were sitting on their books.

When the Greek sovereign debt crisis burst out in April 2010 and gave rise to the first rescue plan in May, banks were considered robust enough to withstand potential losses. Indigent stress tests in July confirmed their apparent good financial health. However, one year later the macroeconomic situation was deteriorating alarmingly throughout the Euro area and recession is looming for the 4th quarter of 2011 and early 2012. Worries for the health of government finances in a much larger set of countries grasped the financial markets, inducing an alarming widening in sovereign bond spreads.

Then, in the summer of 2011 the financial crisis got systemic again. Asset markets plummeted worldwide and European bank shares were hit the most. US mutual funds withdrew deposits from European banks in droves. Counterparty risk came back to the front, making bank funding very expensive. Indeed, the threat of a sovereign default impinges upon the banks by several channels:
• The fall in the value of bank assets raises the funding cost and the vulnerability to shocks in downgrading the value of collaterals.
• Profits are impaired with the disappearance of state guarantee on borrowing costs.
• Rating agencies downgrade sovereigns and banks in tandem, making investors reluctant to purchase bank bond issues, all the more than the opacity of bank balance sheets make them unable to discriminate between robust and fragile banks.

In October 2011 the financial situation of a large number of banks has deteriorated so much that the denial of the urgent need to recapitalize has become untenable. After an initial warning by the IMF urging an injection of capital in all large European banks, the European Banking Agency (EBA) ran stress tests to estimate capital shortfalls. In the meantime the ECB has confirmed its concern for keeping the vital liquidity lifelines open. Since May 2010 it has purchased €160bns in crisis-hit government debt. In October it has announced that it will extend the maturity of its unlimited facility to 12 month loans, lasting until early 2013 and in December it extended to 3-year maturity.

The latest stress scenario in early December 2011 identified an overall capital shortfall of €115bns after core tier-one required capital ratio had been raised to 9%. The bulk of the shortfall obviously impinges upon the banks in debt-ridden countries (Greece, Spain and Italy). However German banks with a capital gap of €13.1bns are in a much more dire shape than French banks (€7.3bns). The trap is the very low price of bank shares that precludes capital-raising via issue of new shares. Therefore banks are busy shedding assets to shrink the size of their balance sheet, threatening a credit crunch that would worsen the incoming recession and make the public debt problem still more acute. This means that nothing less than wholesale ECB purchase of sovereign bonds to keep interest rates at reasonable level will make fiscal consolidation feasible.

The CEPII Newsletter N° 48, 4thQ 2011