Europe’s Naked Banks
WASHINGTON, DC – European leaders are convinced that bank capital is “expensive,” in the sense that raising capital requirements would slow economic growth. But the latest developments in the Greek crisis show that the exact opposite is true – it’s European banks’ lack of capital that threatens to derail European and global growth.
Banks’ “capital” simply refers to their equity funding – how much of their liabilities are owned by shareholders rather than being owed to creditors as some form of debt. The advantage of equity capital is that it is “loss-absorbing,” meaning that only after losses wipe out all of the equity do they need to be apportioned between creditors. Banks’ capital, therefore, is what stands between bad loans and insolvency.
In the Basel III negotiations that concluded last year, the French and Germans strongly favored relatively low capital requirements. This was folly: for their big banks today, more capital would reduce the probability of needing further government bailouts.