Caught short by an EU bank storm

Australian corporate borrowers will feel the pinch as European banks increasingly scale back their lending and dump assets amid the scramble to come up with almost €115 billion ($US154 billion) in fresh capital within the next six months.

The latest stress tests by the European Banking Authority reveal that the biggest capital shortfalls are in Spain and Italy, where banks need to find an extra €26.2 billion and €15.4 billion, respectively. But Germany's banking system was shown to be far weaker than previously assumed, raising the prospect of further government bailouts. The EBA said German banks had a capital shortfall of €13.1 billion, significantly higher than the €5 billion estimated in October.

Germany's second largest bank, Commerzbank, emerged with a capital shortfall of €5.3 billion, well above the €2.9 billion estimated only six weeks earlier. The bank's share price plunged 11 per cent in late trading as rumours of the shortfall spread, fanning fears that the German government could be forced to help recapitalise the bank. The German government already owns 25 per cent of Commerzbank, which came close to collapse during the 2008 financial crisis.

European banks have already been abandoning their global ambitions and focusing on their home markets as the raging eurozone debt crisis has made it increasingly difficult for them to raise funds in traditional markets. The EBA's latest stress tests – which estimated how much extra capital European banks will have to raise to boost their core capital ratio to 9 per cent by June – will only accelerate this process.

Over the past month, Spain's largest lender, Banco Santander SA, has unveiled a string of asset sales, including parts of its prized Latin American operations, in order to boost its capital ratios. In France, large banks such as BNP Paribas and Socit Gnrale have revealed plans to shed assets in order to meet the new capital requirements.

So far, the major Australian banks have shown a willingness to fill the gap left by the departing European banks, even if they're charging corporates a fatter interest rate margin for doing so.

But the pullback by European banks will be much more of a problem in central and eastern Europe. According to Citigroup researchers, loans by European banks or their subsidiaries represent about 100 per cent of GDP in the Czech Republic and Poland. (In comparison, they say, loans by European banks in Asian financial hubs such as Hong Kong and Singapore represent around 40 per cent of local GDP).

The Citigroup researchers also point out that central and eastern Europe will also be much more vulnerable to a protracted recession in the eurozone, which they forecast will begin in late 2012. For instance, Czech and Hungarian exports to the eurozone account for more than 40 per cent of their GDP. Roughly speaking, a fall of 1 per cent in their exports to the eurozone would result in an output cut in these countries of 0.5 per cent.

In addition, the United Kingdom will also be hard-hit by the growing stresses in the European banking sector. The Citibank researchers argue that "a lack of bank financing will probably be an important theme for companies over the next year or so.”

With European banks scaling back their lending, "companies in the UK may have to increasingly turn to vendor and supplier financing for working capital requirements.”