Only the market can liberate Europe

A rising sharemarket has become essential if we are to avoid a European banking crisis. In the last few weeks we have seen how, in current sharemarket conditions, the global capital markets cannot fund the European banks' capital shortfall.

Accordingly this shows how dangerous the European banking situation has become.

At the moment the world is awash with liquidity, so sharemarkets are in trading mode and are rising which is good news. But I have been alerted to the underlying danger by Paul Schulte's Under the Hood (CCBI) email newsletter. It is not going to be easy to raise required capital so European banks will want to shed assets which means new credit will be very tough, compounding the European recession.

In a crisis we are going to either see bank failures or government rescues. That's why many believe it is dangerous to deal with big European banks. Many US banks will not touch them.

In Australia this capital crisis makes our wholesale overseas borrowing requirement expensive. And around the world it makes derivatives that much more dangerous when they involve European banks.

According to the European Banking Authority, European banks require €82 billion ($US105 billion) in additional capital. Schulte says that the EBA has underestimated the scope of the problem, particularly in France, and will eventually have to raise their shortfall estimates. The EBA has taken no account of extra writedowns.

But even using the EBA's understated €82 billion shortfall, there are serious difficulties in raising the money. The Italian bank Unicredit this month tackled its capital shortfall in an equity issue underwritten by 14 European investment banks. During the issue the stock was hammered and the underwriters – many of whom have capital problems of their own – suddenly saw that such exercises could make their own situation much worse if they became saddled with losses.

European bank shares have fallen so far that the capital shortfalls represent a large proportion of bank capitalisations. Schulte says that the €82 billion shortfall equals some 23 per cent of European bank capitalisation. But some of the countries show alarming figures. For example, Portugal's €6.9 billion capital shortfall represents a staggering 172 per cent of its total bank market capitalisation; Belgium's €6.3 billion requirement represents 45 per cent of total bank market capitalisation and the figure for Cyprus is 41 per cent.

The German shortfall of €12.5 billion represents 28 per cent of total bank market capitalisation; Italy is 26 per cent and Spain 21 per cent.

Ratings agency Moody's highlights the risks associated with underwriting bank equity issues during the coming months: "Fourteen banks are underwriting the Unicredit rights issue, which helps spread the risk offering. However, the threat of share-price volatility may make it difficult for future issuers to obtain firm commitments from so many underwriting banks. Such a scenario would be credit negative not only for issuers, but also for underwriters that provide firm commitments, since fewer underwriters leaves those that are committed more exposed to losses if investors react coolly to the offering”.

Only a rising sharemarket can overcome this vicious circle.