Europe's nasty banking feedback loops

As if they weren't pressured enough, European bankers are facing another critical moment over the next few weeks after tabling their recapitalisation plans with their regulators on Friday.

Stress-testing of the banks last December revealed a capital shortfall of €115 billion, most of it within the Spanish, Italian and German banks. Friday was the deadline for submitting their plans for dealing with those shortfalls.

Some of the banks have already moved to address their capital needs – a targeted core capital adequacy ratio of 9 per cent – in the process contributing to the dire state of the eurozone economy by shedding assets and pulling back on lending at a time when governments, facing their own leverage issues, have been imposing fiscal austerity programs.

Only one major bank, Italy's UniCredit, has attempted a major equity raising as part of its response to the stress tests. The less-than-warm reception to its €7.5 billion rights issue, which closed last week, could deter others from attempting to emulate it.

The regulators' responses to the plans won't be known for a few weeks but one assumes that the national prudential supervisors, which will assess the credibility of the measures proposed, would be mindful that there are nasty feedback loops that have developed between banking systems, their national economies and the stability of the entire eurozone.

The economies can only be stabilised if they have properly capitalised and functioning banking systems but to achieve that, already critically over-leveraged public finances would probably need to fill in the gaps in the capital requirements of any banks whose recap plans were deemed inadequate. They need economic growth to soften the impacts of the deleveraging that has to occur but to generate growth they need their banks to lend, not shrink.

Those stress tests last year were the most recent – and most credible – of a series of tests of European banks conducted since the real onset of the financial crisis in 2009. Previous testing in Europe generated considerable scepticism.

Where similar tests in the US have been largely validated by subsequent experience, the earlier European tests have been shown to have been somewhat less than stressful, with the regulators less than keen to force their banks – many of which had previously been bailed out by taxpayers – to raise more capital or radically shrink their balance sheets, or both.

According to the Financial Times today, France and Germany are still trying to fight against the introduction of the proposed Basel III banking regime, which will impose tougher capital and liquidity standards and a simple leverage ratio over the course of this decade.

According to the FT, they want the introduction of the leverage ratio to be deferred from 2015 to 2018, they want to make it less capital-intensive to lend to small and medium-sized businesses and they want the retain the ability within bank holding companies to double-count the capital held within an insurer and its parent bank.

It is unlikely global banking regulators will concede any ground on those issues, even though they will exacerbate the contractionary effects of reduced bank lending.

The battered European banks – and the economies within which they operate – could face another big threat to their stability and an even higher capital requirement if a European Union parliamentary committee that meets tomorrow decides that banks should hold sufficient capital to protect against the true risks of their government bond holdings.

Most of the European banks have big holdings of their own governments' debts, as well as those of other European governments. In fact, because of the focus by regulators on increasing bank liquidity and the sovereign debt elements of the eurozone crisis, they have been encouraged and incentivised to increase their sovereign debt holdings.

Where once sovereign debt was regarded as risk-free, however, the eurozone crisis and the downgrading of most of Europe's sovereign debt issuers have demolished that illusion. If the holdings aren't zero risk it is inescapable that the banks should be holding capital against those bonds.

In keeping with the way the Europeans have approached bank regulation (an approach that has contributed to Europe's current dire position) it appears the committee, if it does propose that capital should be held against sovereign exposures, would recommend nothing should be done until after the crisis subsides.

The markets have, of course, been making their own assessments of those exposures, of the condition of the European banks generally and of the credibility of previous attempts to reassure them by regulators whose credibility has been ravaged by the escalation of the crisis and the continuing inability of the regulators or their governments to develop credible and effective responses.

Self-evidently they haven't been impressed.