Wednesday, March 27, 2013

Euro-bank Leverage Is STILL a Systemic Risk

European bank leverage still remains very high---some have loans and investments that are valued at 50 times equity capital levels---which implies 2% capital "cushion" against declining values of assets (loans).  In other words, if their loan book declines in value more than 2%, then shareholders are 'wiped out' and depositors are put at risk. The total leverage ratio should greater than 5% or higher.

Many of the bank's assets (loans) are bonds of euro-periphery countries which trade from 30 cents on the dollar in the case of Greece to 80 or 90 cents on the dollar for other countries. But, every one of these bonds are being valued at 100 cents on the dollar on every bank balance sheet, ie., they are not marked to market.  Suffice it to say that these sovereign debt holdings have already wiped out the common equity at most banks in Europe and deposits are at risk.  See the chart below  All European banks are either underwater now, or soon will be, in another panic situation.  That would also explain the very low bank stock valuations.

The following chart shows how deficient Euro-bank equity capital remains:

Eurobank Total Leverage (Common Equity to Assets)

Businessweek has indicated recently that, to bring European Bank capital ratios up to OECD standards of about 5% tier 1 capital, the banks need $500 billion dollars of fresh investment capital.  That is some 4 to 5 percent of European GDP---a substantial sum---which is why it hasn't happened.  It's difficult for banks to sell equity now when they have been some of the worse investments in the world and when ALL equity is already "underwater."

With Leverage Still High, Please Don't Scare Away Depositors!!

From, is a chart of loans to deposits for many world banks.  Many European banks have a loan to deposit ratio (LTD) greater than 100% and some over 200%.  High loans to deposits, when greater than 100%, means that banks have had to first borrow money from other banks or entities to re-loan it.  This means that they've taken on additional risk and this risk is amplified when all the banks are loaning to each other.  High ratios means banks have taken on risk that may backfire when there is a panic.  Most US banks had a LTD ratio of less than 100% which is a good thing.

Since deposits are a source of capital funding, the last thing you'd want to do is to cause people to withdraw their deposits when you need more capital!  That's a risk created by the European officials in "scaring off" depositors by their recent actions in Cyprus.

Bank Loan to Deposit Ratios (click to enlarge)
From ZeroHedge,
The chart [above] explains why not only is Europe's several asset constrained, it is also running out of funding, in the form of depositor cash: the most critical bank liability. Remember: without incremental deposits, banks can not invest in new assets, unless they generate cash from operations, and thus grow shareholder equity. There is a problem: as the final chart below shows, Europe, and especially Scandinavia which has consistently remained off the radar, is literally off the charts when it comes to LTD ratios.
With banks such as Danske, SHB, Swebank, DnB, and Nordea literally at 200% Loan-to-Deposits, but most other European banks too, even the tiniest outflow in deposit cash (ala what is happening in the PIIGS) will send the system into yet another liquidity spasm.
Unless banks lower their leverage, by raising equity capital or deposits, as American banks have done, there are going to continue to be bailouts and financial fragility in Europe. Entire countries are at risk.

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