Meeting Capital Requirements in Europe and the Euro

There are a number of ways that European banks are moving to boost their Tier 1 capital and strengthen their balance sheets.

One tactic that is more evident in practice than in observation is adjusting the risk weighted optimization models of the projected capital need (~13.6 bln euros) by adjusting their models.

A Bloomberg report showed Santander reduced its capital need by 5.4 bln euros and BBVA reducing its capital need by 2.1 bln euros. Other banks, including Italy's 4th largest bank, Germany's second largest bank, Europe's largest banks and the UK's largest mortgage bank, have been cited in some press reports tweaking their models to reduce their capital needs.

While regulators and banking authorities may not want banks to rely on adjusting models to meet capital requirements, they are wary about triggering a credit crunch or asset sales that may worsen market conditions and aggravate the crisis.

As European banks have reported their earnings, many have also reported a decline in peripheral bond holdings and this data is more current than the BIS time series that many are relying on for their analysis of cross border exposures.

In late October, Barclay's said it had cut its peripheral exposures by nearly a third in the past three months. In early Nov, RBS said it had reduced its peripheral exposures around 3/4 since the end of last year.

This is not meant to be a comprehensive list, but rather is provided to give a sense of the general pattern. At the end of this week, the European Banking Authority is expected to release individual bank capital needs and criteria for contingent capital that can be used.

Yet the president of the European Banking Federation and CEO of Nordea Bank was quoted suggesting that European banks need to continue to reduce peripheral exposure, including Italian bonds. The pressure on peripheral bonds markets is not just emanating from Europe.

Japanese banks had JPY5.72 trillion of Italian bonds at the end of last year. The MOF data suggests they have sold JPY372 bln through September. Japanese banks have also reduced, on the margins, Belgian bond exposure as well. Japan's largest mutual fund cut its Italian bond holdings in half over the past 12 months, according to reports.

Yet the bulk of peripheral bond holdings are in Europe itself. In some ways, it appears European banks went from the frying pan to the fire. When they fled the imploding US subprime market, it appears they went into the peripheral sovereign bonds in a big way.

On another level of analysis, what is going happening has parallel to the end of WWII. Recall that then Britain and France could no longer afford their territorial empire and had to pull back the frontiers, sometimes grudgingly, like in Egypt, India, parts of Africa and Indochina. Now Europe has to retreat from its commercial expansion.

At the end of Q2 11, ECB data shows the euro zone companies and investors have 4.86 trillion euros of foreign direct investment, 1.8 trillion of foreign equities, and 2.9 trillion of foreign bonds.

Indeed, it appears that the reduction of some foreign exposures has been one of the forces that may explain why the euro is faring better than could be reasonably expected given the interest rate differentials, macro-economic performance and relative asset performances. For example, when some banks found it difficult to access the wholesale dollar funding market, some appear to have reduced their holdings of dollar assets.

Crises Trigger Repatriation

When tensions arise in emerging markets, foreign investors often flee (joined often by some domestic investors). When the developed countries is the source of the tensions, investors seem to reduce foreign asset holdings. The same, arguably to a lesser extent, is also taking place among US banks.Some of these assets may have to be sold to cover the deep holes at home. For example, BNP reported a 40% reduction of their Italian debt holdings in the July-Oct period and cut sovereign exposures by 23%. Commerzbank cut its peripheral (Italy, Spain, Ireland, Greece and Portugal) debt by 22%. . Press reports suggest for example that Spain's two largest banks will raise nearly half.

Some are cutting dividends, diluting current share holders through new rights issues, laying off staff, and selling off assets.