European banks prepare to shrink

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:

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.”

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.

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.

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:

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.

Latest posts by __ADAM__ (see all)


  1. Using debt to buy your own instruments only improves your capital position if you are buying at a discount to par that is greater than currently reflected in your books. You may recall that many of the major banks are marking their own instruments to market on a quarterly basis (it is not obligatory to do so and cannot remember if Commerzbank does this). The other option is if you are purchasing tier 2 and replacing by issuing an equivalent volume of tier 1, but then the impact is 50% at most and depends on being able to issue the new tier 1. Either way I cannot see how Commerzbank can use EUR 643m to buy back EUR 1,270m to bolster capital by EUR 700m. There is a distinct whiff of either your source not knowing what they are talking about or Commerzbank is deploying an uber version of Invisopower.

    • Hi there and greetings to down-under!

      German GAAP does not permit a market valuation of outstanding liabilities to free up capital so Commerzbank has to go a different route than US banks.

      As far as I remember Commerzbank Tier 2 traded at 50-70% of face value before Christmas because the early redemption option after 10y is considered worthless. Again, in the hey-days before the crisis 2008 we had in Germany trendy hybrid finance innovations which were treated for regulatory issues as Tier 1 and for tax issues as Tier 2. And lots of them were underwritten by French banks at Euribor flattish (+20bp) and placed by them into their private clients offshore accounts (Monaco, Luxembourg and Geneva).



  2. >Using debt to buy your own instruments only improves your capital position if you are buying at a discount to par that is greater than currently reflected in your books.

    I believe they are taking advantage of the fact that the market has marked down their bonds. They are therefore buying them back below par and profiting from the transaction. So that is Tier 2 (Bonds) -> Tier 1 ( retained earnings )

    >EUR 643m to buy back EUR 1,270m to bolster capital by EUR 700m

    Yes that doesn’t add up for me either.

    The other question I have is who exactly is supposedly buying all of these assets that these banks claim they will shed to increase their capital ratios ? And why the hell would they pay anywhere near market price for them given there are so many institutions all trying to do the same thing ?

  3. Asset Managers looking for yield and who do not have the same capital and risk (particularly mark to market reporting) as banks will be buyers, however I agree that I cannot see them buying in the volumes needed.

    By the way I view Hedge Funds as a sub set of Asset Managers – they are just better at extracting fees from clients than traditional long only asset managers

  4. [i]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.[/i]

    Trouble is, a fair bit of the “real economy” wasn’t real, but asset bubble driven by easy money. Until the froth has been blown away, we won’t know how much beer there was underneath.