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.

These banks’ potentially troubled assets include, of course, bonds issued by Greece, Ireland, Portugal, and other eurozone countries whose fiscal prospects are now being marked down by financial markets – but that until recently were regarded as “zero risk” by the relevant authorities. If European banks had enough capital, a reduction in the value of Greek and other debt would reduce shareholder equity and disappoint investors, but it would not cause a banking crisis. Unfortunately, European banks do not have enough capital, irrespective of eurozone bailout efforts, because the damage will not be limited to Greece.