European Union Focuses on Banks Rescue Plan

Sources:
FT: EU Banks Could Shrink to Hit Capital Rules
FT: EU Examines Bank Rescue Plan
Spiegel: Europe Begins Working on Plan B for the Euro
USA Today: EU Plans to Force Banks to Raise Capital Soon
WSJ: EU Pushes Bank Plan

Last Wednesday, European Commission President Jose Manuel Barrosso laid out a general overview of the Commission’s recent proposal to force the biggest banks in the European Union (EU) to raise billions of euros to better withstand the region’s escalating sovereign debt crisis. The extra capital will help banks cover any losses they may incur as a result of the crisis and should help reduce investors’ uncertainty about the region’s stability. The plan is the latest effort to restore confidence in the Eurozone and overcome the crisis.

Under the new proposals, there will be stricter review of the banks’ capital ratio (the amount of capital the bank holds in cash compared to its total assets, which include outstanding loans the bank has made), which determines the banks’ ability to absorb losses. The European Banking Authority is likely to set a higher capital threshold—around 9% (that is, if a bank has $100 of total assets, it must keep $9 in cash on hand at all times)—although this number could change as the details of the plan are worked out. Current rules only require the banks to maintain capital of 5%-6% of total assets. The banks will have six to nine months to raise the additional capital needed to maintain the 9% ratio.

The European Commission recommends that banks in need of additional capital should first seek it from private sources. Doing so may require banks to convert some of their outstanding debt to equity—a process in which the bank’s creditors agree to cancel some or all of the debt the bank owes in exchange for ownership of a portion of the bank. If this effort proves unsuccessful, national governments should then be ready to provide the necessary capital. The European Financial Stability Facility (EFSF) will be available to lend money to the governments for them to use to recapitalize their banks but only as a measure of last resort. Lastly, the Commission stated that banks should be prevented from paying bonuses to employees and dividends to investors before their capital levels meet the new standards. The Commission is still working out the final details of the plan and will not likely reach a final decision until the EU finance ministers meet at the end of the month for the European leaders’ summit.

Banks must recapitalize to be strong enough to absorb losses on Greek government bonds and other sovereign debt they hold to avoid having to be “bailed-out” by their national governments. Banks estimate that they could face a 60-80% loss on Greek bonds if Greece defaults. This means that banks would have to use their capital reserves to cover reserves to cover these losses. If banks are not adequately capitalized to handle such losses, they may become insolvent—they would not be able to pay their expenses and thus would “fail.” Bank failure is a major concern, because banks are deeply interconnected across national borders. If major banks begin to fail in one country, it would risk dragging down other banks across the Eurozone, putting additional strain on the already weak region.