In a note released on Tuesday, GMO, the global asset management firm headed by Jeremy Grantham, writes that ”European banks need tons of money” to correct capital shortfalls. This much, we know.
But the five scenarios used by Richard P. Mattione, the firm’s head of macroeconomic research, for why banks will need to raise much more capital should prove familiar to FT Alphaville readers. Mattione uses data from the July EBA tests and July BIS data, so be warned. In fact, there are a few points here that seem to be behind the results of the latest EBA efforts.
Nevertheless, it’s a neat summary of a genuinely stressful stress test, and of interest to those wondering what one of the big players in Boston is thinking. Excerpts and charts below, with our emphasis and links.
Scenario 1: Excluding deferred tax assets (DTAs)
A key question is how much real capital the banks currently have. Here we insist on one adjustment to the EBA data in all scenarios; since most DTAs are not money at hand but merely a promise of money in the future, they should not be counted in capital. If that were the only adjustment necessary, the situation would not be so severe. For the 89 banks in this sample, replacement of DTAs with new capital would require approximately 36 billion euros of new Tier I capital raisings to reach a Tier 1 capital ratio of 7%. Banks from Italy and Spain, which would need 11 billion euros and 18 billion euros of new capital, respectively, represent almost all of the needs (see Exhibit I). The amount would roughly double, to 76 billion euros, if the capital standard were set at 8%, and more than triple at 9%.
Scenario 2: Incorporating Greece’s sovereign debt
First, a bit of methodological housekeeping: it’s not crystal clear from the note what Mattione assumes about PSI (although we can infer he holds out little hope for any recoveries), or what he assumes will happen to all that off balance-sheet debt. No knock-on macroeconomic effects of a Greek default are assumed. Mattione does assume that where “a few banks” have to write off all existing capital, they’ll re-emerge from a position of zero — not negative — capital.
The incremental amount of capital necessitated by Greek’s default is surprisingly small for all the ink that has been spilled on Greece. Banks need an extra 17 billion euros of capital to hit the 7% standard, concentrated mostly on the Greek banks, and 30 billion euros if the banks must achieve a 9% Tier I standard (see Exhibit 2). The market is unlikely to provide that level of recapitalization for Greek banks before wiping out existing shareholders, so, effectively, the recent default has ended the Greek banking system as previously known. Otherwise, things look rather similar to the first scenario, which only examined the exclusion of DTAs.
Scenario 3: writing down IIPS debt
The key assumption here is that banks will need to “creat[e] a capital buffer equal to 10 per cent of the face value of those holdings”, which Mattione says is “in line with market discussions of the last few months”.
Creating a capital buffer equal to 10% of the face value of those holdings, even in the case of a mere 7% Tier I capital ratio, drives the financing need for European banks from 53 billion euros to 94 billion euros, with virtually all of the incremental needs focused on Italian and Spanish banks (see Exhibit 3)… With bank capitalizations not that much higher than the new capital needs, equity investors can survive but will not be smiling: as of December 7, 2011, the needs projected here represent 122% of the market capitalization on average for the Italian banks, and 49% for listed Spanish banks. This implies dilutions of 34% for French banks, but 50% for German banks.
Scenario 4: adjusting for rising bund values
Ain’t going to happen, according to the EBA’s most recent statements, but in case you were wondering:
If a 7% Tier I capital ratio is desired, only 7 billion euros of financing needs are removed, though it does practically end the financing needs of German banks (see Exhibit 4). In the 9% Tier I capital scenario, the reduction is from 219 billion euros to 199 billion euros. This is mostly to the benefit of German banks, with capital needs of a mere 11 billion euros even in the 9% Tier I capital scenario, with an implied dilution of 32% for the holders of German bank stocks. One can understand why Germans have been the main proponents of this solution.
Scenario 5: applying a non-zero per cent risk weighting to sovereign bonds
Also know as, the trouble with Basel 2.5. Here, Mattione assumes DTAs are not counted and (conservatively) there’s a50 per cent haircut on Greek debt but there are no other losses on sovereign debt as per scenario 3.
Even in the case of a mere 7% Tier I capital ratio, treating sovereign debt as a risky asset drives the financing need for European banks to 110 billion euros (see Exhibit 5). This scenario is tougher on French and German banks than on Italian and Spanish banks in comparison to Scenario 3. It is still the Spanish and Italian banks that need the most capital – 33 billion euros and 22 billion euros, respectively. The heavier incremental burden on French and German banks results from their large amounts of sovereign claims outside the PIIGS countries, while Italian and Spanish banks have their sovereign claims in most cases focused on PIIGS countries (Italy for the Italian banks, Spain and to a lesser extent Portugal for the Spanish). If the capital standard is raised to 9%, the needs are unimaginable: 289 billion euros.
This scenario, obviously, is one that France and Germany will want to avoid. Mattione concludes that we’ll see further sales of the family jewels, deleveraging is still to begin in earnest. His solution, while logical, also seems to assume that Germany hasn’t noticed the ticking neutron bomb — so to speak — all by itself. And there’s no mention of the recent actions by the ECB. At any rate here it is:
One obvious question is whether one should move to so extreme a scenario as provisioning against all sovereign debts, or even all European sovereign debt. Ever-expanding capital requirements can be the neutron bomb of banking regulation; the branches might still be standing, but the banks themselves would be barely recognizable if they were to survive the cataclysm. Once the Germans understand that they too are exposed, they presumably will be amenable to more reasonable approaches to the sovereign debt problems, such as more generous volumes and maturities at collateral facilities or even a direct use of the ECB to support sovereigns so as to avoid crushing the banking system.
Good luck with that — Boston sure is a long way from Berlin.
Related links:
Is Basel 2.5 hitting the bond market? – FT Alphaville
EU Banks Selling ‘Crown Jewels’ for Cash – Bloomberg