European banks prepare to shrink

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Although the headlines are quiet at the moment there is still quite a bit occurring behind the scenes in Europe. Obviously everyone is still waiting for a resolution of the Greek situation and that story is changing by the hour. The latest is that there is some sort of deal, but it won’t be available until noon Friday ( Greek time ) and it is supposed to be tabled at the European summit on Monday. I have no idea if this is the case as it is about the 50th time I have read the same thing so we will all just have to wait and see.

As I have been reporting over the last few weeks there is mounting pressure on the European banks re-capitalise as to meet the requirement of core tier 1 capital ratio of 9 percent over risk weighted assets by June 30, 2012. This is now coming to a head with banks required to deliver a “credible” plan to European banking authority as to how this is to be achieved by Friday.

Banks have several options to find the capital required. They can retain earnings, shrink their loan book, convert hybrid debt into equity, buy back their own debt, sell assets, cut expenses (including staff salaries ) and/or cut dividend payments to shareholders.

The authorities appear to be fairly unimpressed with two institutions in particular:

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European regulators are convinced that two of the continent’s banks will fail to produce credible plans to plug capital deficits by Friday’s deadline, exposing both to the risk of full or partial nationalisation.

Officials said that it looked “almost inevitable” that a fresh injection of state funds would be needed at Italy’s Monte dei Paschi di Siena and Germany’s Commerzbank. “These are the big cases,” said one.

Since that report was released Commerzbank have announced that they believe they will reach the required capital limited without additional state funds:

The company anticipates boosting its Core Tier 1 capital or, trimming equivalently its risk-weighted assets, by approximately 6.3 billion euros by June 30, 2012. Commerzbank also said it will continue to guarantee the supply of credit, in particular for Germany’s Mittelstand, or SME business, as well as for its large corporate customers and institutional clients.

Commerzbank said that an estimated 57 percent of the requirement was met by year-end 2011 as a result of Core Tier 1 relief amounting to 1.6 billion euros and also retained fourth-quarter earnings of about 1.2 billion euros.

Martin Blessing, chairman of the board of Managing Directors of the bank stated, “Within just a few weeks, through to the initiated measures we have already reduced our Core Tier 1 capital requirement by around EUR 3.0 billion by year-end 2011, and thus already fulfilled almost 60% of the EBA capital requirement. In the coming five and a half months we intend to decrease the need for Core Tier 1 capital by up to a further EUR 3.3 billion by means of the implementation of a number of measures.”

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Those measures include shrinking risk-weighted assets, halting all new loans aside from clients doing business in Germany and Poland, suspending all new business in certain operational areas, retaining earnings and tightening up the cost structure including sacking staff.

What isn’t mentioned in the article, but I suspect is happening, is that Commerzbank, like other European banks, is using the liquidity provided by the LTRO to continue to re-purchased its own financial instruments, as it was doing in December:

Commerzbank AG bought back more hybrid capital from investors than the company had initially planned as Germany’s second-largest lender fights to bolster capital and avoid a second taxpayer-funded rescue.

Commerzbank will spend about 643 million euros ($835.2 million) to repurchase a nominal 1.27 billion euros of securities, the Frankfurt-based company said today. That’s more than the 600 million euros the bank said on Dec. 5 that it intended to spend. The transaction will boost core Tier 1 capital, a measure of financial strength, by more than 700 million euros, according to the company’s statement.

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As I mentioned yesterday, this process is all well and good for the banks (and their share price ) in the short term, but it is seriously impeding the recovery of the real economy as these banks become “zombified” and close down their loan books.

This exact message was noted by Moody’s today in a report titled “Euro Area Debt Crisis Weakens Bank Credit Profiles” (sorry requires login):

To lower actual and perceived risks, many banks have begun to reduce sovereign and interbank exposures, in particular non-domestically, as discussed in more detail below. Bank deleveraging raises the prospect of a destabilising feedback process: bank asset sales can cause the market for certain bank assets, including sovereign debt, to become stressed if these sales create excess supply, which can force further selling, resulting in deepening market stress. Furthermore, if banks extend less credit to governments, businesses and households, this can curb economic activity, with adverse implications for borrowers’ payment ability and ultimately for bank asset quality and solvency.

Making the threat of bank deleveraging particularly relevant, banks play a larger role as financial intermediaries in the euro area than, for example, in the US. The assets of all euro area banks amounted to the equivalent of $27.8 trillion at year-end 2010, about twice the size of all US banks ($14.3 trillion). At the same time, bond and equity markets are much larger in the US than in the euro area.

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Although, as noted by Moody’s, these actions will ultimately lead to a deterioration in asset quality and stability because they will add to the already deflationary pressure of government austerity, that certainly hasn’t stopped banks taking these actions.

This is why we are seeing charts like this from Italy:

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And statements like this from the Spain:

Spain may miss its deficit target of 4.4 percent of gross domestic product in 2012 amid signs that economic growth assumptions may fall short, the country’s Budget Minister Cristobal Montoro said in a pre-released interview with the Financial Times Deutschland newspaper.