European Banks

The markets had a huge rally yesterday with the news of the apparent resolution to the Greek debt problems.

European bank share prices soared, led by a rise of more than +20% in French bank stocks.

As I will explain, I can understand why banks are rallying - they're getting bailed out (again).

What I can't figure out is why the solution is anything but very bad news for European economies.

Here's the part that I'm focused on: the plan calls for banks in Europe to raise capital between now and the end of June next year. The figures being thrown around are around 110 billion euros, or about $150 billion.

The idea is laudable: banks need to raise more capital in the event of other sovereign credit problems, especially in countries like Ireland, Spain, Portugal or even (gulp) Italy.

Problem is, most bank stocks in Europe are trading below book value, just like in the U.S.

Issuing equity capital below book value is a sure-fired way to kill your stock value, and it seems logical that most bank managements will be reluctant to do so.

Which then leads to the real heart of the matter. For this, let me show you a very simplified bank balance sheet:

Assets

Loans and Investments 100

Total Assets 100

Liabilities & Capital

Deposits, Borrowings* 94

Bank Capital 6

Total Liabilities and Capital : 100

What you can see here is a fairly typical balance sheet which has 6 euros supporting 100 euros of loans and investments. This ratio - 6 euros for 100 euros of assets - is 6%, which is roughly where most of the European banks currently stand. This 6% figure is called the capitalization ratio.

The agreement reached yesterday called for bank capitalization ratios to be raised to 9%. The question is: how can this be done when bank stocks are trading below book value?

Simple algebra will tell you that if you're not going to sell stock, you have to reduce your assets.

If you have 6 euros in capital, and you want the capitalization ratio to go to 9%, you have to shrink the amount of assets to 67 euros, or about one-third less than their current levels.

If this is the case, this will be hugely depressing for Europe. Reducing loan portfolios by 33% between now and next June doubtlessly will entail economic pain. Shrinking the debt markets so quickly means less credit available for all kinds of meaningful economic purposes.

Now, some of the people I have spoken to say I am being too pessimistic.

First, it was announced yesterday that the authorities will be watching the banks very carefully to make sure they don't just shrink their balance sheets in the manner I am suggesting. Honestly, I don't know how effective moral suasion can be in this case, but maybe it will work.

Second, the banks themselves are claiming that they can simply retain more earnings and build capital through business operations. Well, maybe, but these are big numbers, and loan growth in Europe is really slow.

Oh, and the banks might cut their dividend payouts (as French PM Sarkozy suggested yesterday) to retain more earnings. But how does this make bank shares attractive to investors to provide needed capital?

Maybe the banks don't need to shrink their balance sheets: maybe they can just sell off huge chunks of their loan portfolios to other investors, which means that the credit will still remain in the system.

Problem with this happy scenario is that it implies that banks will be able to sell their loan portfolios at attractive prices. We tried this in the U.S. in 2008, and essentially failed - the bids were at huge discounts to book.

If you are a buyer of bank loans, and you knew the banks had to sell, are you really going to make an aggressive bid?

I could go on, but you can see my problem. If the politicians force their solution on the banks, and the "happy" solutions don't pan out, it has the danger of tipping a fragile economic situation into something more serious.

More more ominous note: Almost immediately after the Greek deal was announced yesterday, the Irish Prime Minister was quoted as saying, hey, we would like that deal also - why should we be forced to pay back all of our debt at face value if the Greeks only have to pay 50%?

Look for the rest of Southern Europe to follow Ireland.

Lots to ponder this weekend.

BTW: The funding of the loans is largely done through deposits and borrowing. In the case of the European banks, they make extensive use of the money markets. This makes the Europeans more vulnerable to changes in credit perceptions, since lines can be quickly pulled if any lender becomes nervous.