Banks and Basel III

A few days ago, global banks won a four year delay in the implementation of the Basel III liquidity coverage ratio.  European banks were up as much as 2.1% that day according to Bloomberg.  While the delay should give the European banks more time to build up their capital ratios, it does bring up a key aspect of the financial/sovereign debt crisis of the last several years.  Leverage.

Leverage was a major factor in the financial crisis in the US in 2008.  While some of this was addressed with capital injections from the federal government (TARP) which were later repaid,  this was not done in Europe.  A recent piece from the OECD highlights this.  There are several ways to measure a banks financial strength.  The ratio of Core Tier 1 Capital to 'risk weighted assets' is one.  The major global banks generally pass this standard.  However, it is subject to questioning, since the issue of how to risk weight the assets is left up to the bank.  Thus sovereign debt assets can be classifed as 'risk free'.  While one can argue that German Bunds and US Treasuries are risk free, it is a much harder case to make for Greek, Portugese, Irish, or Spanish, and Italian bonds.

To eliminate this, you can look at Core Tier 1 Capital to 'unweighted assets' and here the picture is very different.  The european banks face a significant shortfall.  In aggregate, they would need to raise capital equal to over 4.2% of GDP (approximately 400bn euros) to meet the 5% well capitalized ratio.   While Greece being high on the list may not be a surprise, the rest of the chart may be.  The banks of such stronger countries such as France, Germany, Holland and Finland all would need to raise more capital than the 4.2% of GDP average for the Euro area.  In contrast, Spanish and Italian banks would appear to be on much stronger footing. 



Source: OECD

The delay in implementing some of the Basel III rules will help European banks in growing their capital through retaining earnings.  However, it does not get to the heart of the matter, that many of them (particularly in the north) are still highly leveraged and have not raised the capital necessary to assure the markets.  This is part of the reason that european countries have 'kicked the can' down the road so often and been willing to fund bailouts.  Their own banks would have a difficult time handling the fallout.  European banks turning the corner on their capital adequacy, will be a strong sign that the chronic crisis is also turning.