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28th October 2011

Banks and the Euro crisis deal
Opinion

The main strands of the deal to sort the sovereign debt crisis in Europe are:

- 1 That major banks must raise their Core Tier 1 (CT1) capital to 9% by June 2012. It is understood 70 banks will be required to meet this new ratio involving the raising of around €106bn (£92bn $148bn ¥11.2tr Y938bn) of new capital.

- 2 That banks will in general hold sovereign debt at market value on their balance sheet.

-3 Greek sovereign debt will be 'voluntarily' written down by the banks to 50% of current value. Banks have written down Greek sovereign debt by varying amounts to date. (Typical writedown to date within the Eurozone countries is in the 20-25% range).

- 4 The Euro bailout fund (European Stability Fund) has a theoretical 'face value', of €1tr, £872bn $1,393bn ¥105.7tr Y8,849bn

On the basis that some progress had been made there was an immediate favourable reaction from most markets. The crisis has subsided for the moment but matters are far from solved. Some of the issues arising are:

The Euro countries insist banks will be required to raise new capital and will not be allowed to reduce lending in order meet the rules. In practice how can this be enforced? There has been a pantomime existing in the UK for almost three years where the banks have increased capital by lending less. The banks have insisted they are willing to lend to SMEs but the SMEs don't want to borrow and the SMEs reply "Oh yes we do want to borrow" (at least until recently). If business cannot borrow more, it is hard to see where European economic growth will come from. Without economic growth it then becomes impossible to reduce sovereign debt. Many alternative forms of business borrowing, such as finance house / asset finance, have reduced in size or were acquired by mainstream banks in recent years. An expansion of the company bond market to encompass smaller businesses would seem unlikely in the near term and likewise significant IPO activity within this sector. Most of all it is not explained why banks with no exposure to high debt Euro countries (either sovereign or to other borrowers) should have to meet this CT1 level.


Three quarters of the new capital required is by banks in the high-debt European countries, now labelled the 'peripheral economies', of Portugal, Italy, Greece and Spain.

Ireland, the first country requiring a rescue is considered by most to be well covered and showing some early signs of recovery. Broadly it does not figure in the recent discussions.

Portuguese banks, as a proportion of the size of the economy will need a reasonable level of new capital, however as a proportion of the total new banking capital required, is only likely to be 5 or 6%.

Italy is considered the country with the most concerning sovereign debt problem, its banks are proportionately less exposed than in other countries. This is in part because French and German banks were more willing to buy Spanish sovereign debt, and part, as in the case of BNP Paribas, because other European banks bought Italian banks acquiring the sovereign debt with it.


Greek and Spanish Banks are considered to need the most with the two countries banks required to raise more than half of the total (circa €55bn). (A full break down of bank capital requirements by country can be found on the European Banking Authority website:
http://www.eba.europa.eu/News--Communications/Year/2011/The-EBA-details-the-EU-measures-to-restore-confide.aspx . See also Newslink article - Santander can exceed 9% CT1 ratio without going to market.

The IMF proposed that Greek sovereign debt be written down by 75% and it is unclear whether 50% will be considered adequate in the medium term. Whether this is accepted as 'voluntary' has a number of important implications. For the banks holding sovereign debt the fact it is voluntary is to their significant disadvantage. Whilst the arrangement is voluntary they cannot call on any Credit Default Swaps they hold to pay out. It is understood from certain published data that big lending banks to Southern Euro countries have between 20% and 40% of their total lending (sovereign and other) covered by CDS. The decision to brand the action voluntary is almost certain to be challenged. The reverse of this is also true with serious danger to the survival of some financial organisations if writedowns were to be imposed on Italian sovereign debt and it was declared an official default. There are many other ramification if this move is termed an official default which would ripple through with downgrading of banks' credit ratings and a significant delay to the recovery of the countries affected.


There are doubts as to whether €1tr will be enough as a bailout fund. This is further complicated in that the actual cash in the fund currently is only one quarter of this amount and only gets to the €1tr figure by the fund itself borrowing or attracting investors. Details of this have still to be worked out. Middle East sources have been suggested as investors and may be willing. The lenders will extract a price for this, which may in turn affect the rate at which the fund charges the countries in need. That rate determines the cuts the country must make, the speed of repayment, and its economic growth rate which in turn affects the speed at which it can reduce its debt.