A month ago we quantified that just the overt European bank undercapitalization (excluding spillover effects from counterparty liability and derivative exposure) resulting from non-performing loans, is a staggering €500 billion. These NPLs "reduce the capacity of banks to lend, hindering the monetary policy transmission mechanism. Bad debts consume capital and make banks more risk averse, especially with respect to lending to higher risk borrowers such as SMEs. With Italy (NPLs 13.4%) now following the same dismal trajectory of Spain's bad debts, the situation is rapidly escalating (at an average of around 2.5% increase per year)." The implied conclusion is that Europe has kicked the can far longer than it should, and as a result its banks have become zombie shell with unprecedented accrued losses, supported explicitly by their various governments, and thus, by the ECB, which is now in the business of preventing sovereign failure (despite its repeated promises otherwise).
And since the topic of quantifying how big the sovereign assistance to assorted banks - both in Europe and the US (which Bloomberg calculated at $83 billion per year) - has become a daily talking point, we are happy to read that Harald Benink and Harry Huizinga have reached the same conclusion as us in their VOX analysis, and further have shown that in Europe the implicit banking sector guarantee by the state is a whopping €650 billion.
Until now, Europe’s banking sector has been kept afloat by implicit state guarantees of virtually all liabilities. Michiel Bijlsma and Remco Mocking (2013) of the CPB Netherlands Bureau for Economic Policy Analysis find that in 2012 these guarantees provided banks in Europe with an annual average funding advantage amounting to 0.3% of total assets. They base this estimate on a comparison of banks’ diverging credit ratings in scenarios with and without government bailout support. An annual funding advantage of 0.3% of assets can be capitalised to be equivalent to 2% of total assets, on the assumption of a discount rate of 15% commensurate with banks’ uncertain earnings prospects. Given total banking assets of €33 trillion in the Eurozone, we are talking about an implicit guarantee of about €650 billion.
Benink and Huizinga go so far as making the call for an urgent recapitalization of Europe's ban:
Europe has postponed the recapitalisation of its banking sector for far too long. And, without such a recapitalisation, the danger is that economic stagnation will continue for a long period, thereby putting Europe on a course towards Japanese-style inertia and the proliferation of zombie banks.
So while the recent advent of the Japanese Carry Trade has been a useful distraction to the insolvency of Europe's banking sector, the underlying reality, as confirmed by the build up of massive unrecognized losses, is only getting worse, and the market is well aware of this:
Banks are already saddled with ample unrecognised losses on their assets, estimated by many observers to be at least several hundreds of billions of euros and mirrored by low share price valuations, and an additional loss of their present funding advantage will be crippling.
On average, the market-to-book value of European banks now is about 0.50 (see Figure 1). This indicates that accountants’ estimates of bank capital are far too rosy, and that banks have substantial hidden losses on their books. In a recent speech Klaas Knot (2013), Dutch central bank president and European Central Bank governing council member, noted that restoration of banks’ balance sheets is a crucial requirement for economic recovery. To facilitate this process, Mr Knot states, it is essential to create transparency about losses in the banking sector and to have an orderly resolution of lossmaking assets. Without this, banks will remain restrictive in making new loans. Mr Knot adds that the planned European banking union offers an appropriate opportunity for speeding up the resolution process.
Furthermore, since European banks are unable to grow into their balance sheets using profits (for the simple reason that stripping away accounting gimmicks the vast majority of European banks are hardly profitable, if outright unprofitable), it will mean that the Cyprus bank resolution scheme will soon be coming to a seemingly healthy European bank near you.
The plight of Europe’s banks worsened considerably when Jeroen Dijsselbloem (2013), Dutch finance minister and Eurogroup president, stated that the approach taken in Cyprus of resolving failed institutions without using taxpayer money would in future preferably apply throughout the Eurozone. Consistent with this, Wolfgang Schäuble (2013), German finance minister, recently stated his desire ‘to ensure that enrolling taxpayers to rescue banks becomes the exception rather than the rule’, and that to achieve this ‘we need credible EU bail-in rules as soon as possible’.
Financial markets understood Mr Dijsselbloem’s message, as shown by a subsequent decline in the share prices of many institutions. Very low bank valuations imply that they will find it very difficult to recapitalise themselves by issuing equity or debt that is convertible into shares – in part because share issuance would further dilute the value of implicit state guarantees. Low share prices, in effect, imply that banks can raise only limited capital by issuing new shares, and that they may need to accept reduced issuance prices. Very few large European banks are raising capital by issuing new shares, no doubt as they realise that this is not in the interest of current shareholders. As exceptions, Deutsche Bank raised almost €3bn in April, while Commerzbank announced plans to raise €2.5bn through a heavily discounted rights issue in May.
The VOX authors' conclusion - the time to stop kicking the can has arrived:
Time to recognise losses
It is now urgent to start recognising losses on balance sheets to avoid a proliferation of Japanese-style zombie banks in Europe. To facilitate this, we advocate conducting a new and thorough stress test soon, similar to the one administered by US supervisory authorities in 2009. Of course, the financial position of most governments in Europe is much worse than that of the US in 2009. So Europe needs to take a path towards recapitalisation that in some respects differs from the earlier US approach.
- First, a credible stress test should assess the losses hidden on the balance sheet for each bank, as well as the likely cost of the removal of implicit guarantees of all liabilities.
This will result in an estimated capital shortage, taking into account capital levels as required by international bank supervisors. Recently, the Financial Services Authority (2013) conducted a stress test of UK banks, resulting in a necessary downward adjustment of reported regulatory capital of about £50 billion, and a resulting regulatory capital shortfall of £25 billion. The estimated capital shortfall of £25 billion is likely to be a low estimate, as it is by and large predicated on the continuation of implicit state guarantees in the UK. At any rate, thorough stress tests in other European countries are likely to reveal sizeable capital shortfalls as well.
- Second, supervisors need to assess whether the capital shortfall can be financed by international capital markets and/or national governments.
In case the required amounts are too high, the bank immediately must be entered into a resolution and restructuring process imposing some losses on unsecured creditors (the Cyprus model).
The legal basis for this resolution and restructuring would be an intervention law, which some European countries may need to enact through emergency legislation. Most banks in Europe, in contrast with their Cyprus counterparts, have significant financing by bond holders and can be recapitalised by imposing losses on holders of subordinated and common debt without infringing on savings deposits.
- Third, in the event that capital shortfalls are relatively small, supervisors could instead implement the US model.
This would mean that banks are given a limited period of time to issue equity on international capital markets, after which national governments step in to provide the remainder of the equity shortfall.
What is coming next is the New Normal's new favorite phrase: share sacrifice. Supposedly by unsecured creditors at first:
The way in which Europe recapitalises its problem banks now has a direct impact on the design of the future European banking union. If many banks are recapitalised by imposing losses on unsecured creditors, such as holders of subordinated and common debt, this is likely to be reflected in the design of the single resolution mechanism that will determine the extent to which bail-ins are mainstreamed in future bank resolutions in the EU.
Although coupled with the recent push to sequester large bank deposits, in part or in whole, and amounting to as much as $32 trillion globally under the guise of punishing tax evasion, one can be certain that secured debt holders, not to mention bank deposits, will also be impaired. It also means that when the most recent coming of the Japanese carry trade finally unwinds, and judging by the recent plunge in the Nikkei and surge in the JPY, its days may be numbered, look for the knock off effects in the European financial and sovereign bond market to usher in what may be the perfect storm of both Japan and Europe suddenly going from stable to highly combustible at the same time. Which will once again leave Ben Bernanke as the only central bank with any gunpowder left to preserve and restore stability in the "developed" world.