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European Banks were already the most undercapitalized banks before the crisis...

Here is a graph (from the Economic and Fiscal Statement 2008 written by the Department of Finance of Canada) of the Bank Leverage Ratio (assets as a multiple of capital). One can see that the banks of the Euro Area were clearly the more leveraged ones before the Subprime Crisis...

(click to enlarge) source

...And they still are

(click to enlarge) source

With this graph from the IMF, we can deduct the leverage of the banking system in different countries. The leverage of the Banks in France and Germany are dangerously high...

(click to enlarge)

Official Basel III capital shortfall of 383.3 billion according to EBA (as of June 2012)

On March 19th 2013, the EBA (European Banking Authority) published the results of the Basel III monitoring exercise as of 30 June 2012 (source).

In this document the EBA, is evaluating the impact of a full implementation of the Basel III framework (as of June 30th 2012). For instance the ET1 (Common Equity Tier 1) would have decreased from 11.1% on average to 7.8%.

The changes in the capital ratio are in almost equal parts due to the changes in the definition of capital & regulatory adjustments (mainly because of the deduction of Goodwill in the calculation of Tier 1 capital) and the changes related to the calculation of Risk-Weighted Assets (the introduction of CVA capital charges increases the RWA).

The EBA considers that the capital shortfall to meet the regulatory capital requirement for all 157 banks analyzed was EUR 383.8 billion under full implementation of Basel III (as of June 30th 2012). This is clearly a lot of money... but would it really be enough to truly protect the European banking system against a systemic crisis?

As a comparison, the sum of profits after tax and prior to any distributions across the group 1 was EUR 65.7 billion (page 6 of Basel III monitoring exercise) during the second half of 2011 and first half of 2012 for a total capital shortfall of 348.5 billion.

I give the Liquidity Coverage Ratio (LCR) and the Net Funding Stable Ratio (NFSR) a miss, since the ECB is clearly supporting the liquidity of the banking system through the Long-Term Refinancing Operation (LTRO).

But Basel III capital requirements are too low

The true question is will the Basel III capital requirement be enough to protect the banking system against an increase in credit risk. I remember that studying for the Financial Risk Manager designation, I was unable to find any reason for the CET1 to be required to be only 3.5% (as of 2013) of RWA under Basel III. So I decided to make some researches on that and I discovered that there was no empirical reasons (if you find one, please send me a message)...

Knowing that the Basel III leverage ratio (CET1 / Total Assets) of the European banking system was between 3% and 3.6% as of June 2012 (source: Basel III monitoring exercise as of 30 June 2012 page 7) - which is equivalent to a leverage between 27.77 & 33.33 - one ought to understand that with increases in non-performing loans, the banking system may be in jeopardy.

David Miles recommends a ratio equal to 20% of RWA

According to David Miles (source), who was a member of the Monetary Policy Committee from June 2009 to June 2012:

"Our estimate of optimal bank capital (by which we mean equity) is that it should be around 20% of risk weighted assets. This is much higher than the 7% level* agreed under Basel III. It might sound like 20% is a dangerously high figure. But since risk weighted assets for many banks are between 1/2 and 1/3 of total assets then even with equity at 20% of risk weighted assets debt would be between 90% and 93% of total funding. The notion that this is insufficient debt to capture any benefits from debt discipline seems unlikely."

*Common equity plus capital conservation buffer.

As always a clever man does, he has tried to find an answer in history.

(click to enlarge) UK Banks leverage and real GDP growth (10-year moving average) source

Academic searchers recommend a leverage ratio equal to 15% of total assets

In a letter published in the Financial Times (source), the signatories - namely Eugene Fama, William Sharpe, John Cochrane, Peter DeMarzo and much other - claim that "if a much larger fraction, at least 15%, of banks' total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any."

Remember that this 15% leverage ratio (CET1 / total assets) is approximately equivalent to a 30% to 45% CET1 / RWA.

Of course this level of CET1 will certainly never be implemented!

What would be the capital shortfall of the European banking system if banks were asked to comply with a CET1 equal to 20% of RWA?

  • 1st way to estimate the capital shortfall with public information

(click to enlarge) source : Basel III monitoring exercise as of 30 June 2012.

According to the BEA Results of the Basel III monitoring exercise as of 30 June 2012, the capital shortfall for group 1 banks is EUR 348.5 billion for a total capital requirement of 8.0% plus a capital conservation buffer of 2.5% plus the capital surcharge for G-Sib and EUR 50.0 billion for a total capital requirement of 8.0%.

According to the Financial Stability Board (source), there are 29 G-Sib in the world. The surcharges for G-Sib are the following: 2.5% for Deutsche Bank (DB) and HSBC (HBC), 2% for Barclays (BCS) and BNP Paribas, 1.5% for RBS (RBS), 1% for Groupe BPCE, Group Credit Agricole, Santander, Société Générale (OTCPK:SCGLY), ING (ING), Nordea, Standard Chartered and Unicredit. In conclusion, we can approximate by 1% the impact of the G-Sib capital surcharge on the total capital shortfall of Group 1.

Thus a CET1 capital requirement of 20.0% would result in a capital shortfall for the group 1 at least of:

(348.5 - 50) / (10.5 + 1.0 - 8.0) = EUR 85.3 billion / 1% increase in CET1 capital requirement above 10.5% + 1% (Surcharge for G-sib)

(20.0 - 10.5 + 1) x 85.3 + 348.5 = EUR 1,073 billion

Coverage of group 1 is 100%.

As a point of reference the sum of profits after tax prior to distributions for group 1 banks between July 1st 2011 and June 30th 2012 was EUR 65.7 billion. This was a bad year but still...

The capital shortfall for group 2 banks is EUR 35.3 billion for a total capital requirement of 8.0% plus a capital conservation buffer of 2.5% and EUR 12.4 billion for a total capital requirement of 8.0%. Thus a CET1 capital requirement of 20.0% would result in a capital shortfall for the group 2 of at least:

(35.3 - 12.4) / (10.5 - 8.0) = EUR 9.16 billion / 1% increase in CET1 capital requirement above 10.5%

(20.0 - 10.5) x 9.16 + 35.3 = EUR 122.3 billion

Because aggregate coverage of group 2 is 27%, total shortfall for banks represented by group 2 is approximately:

122.3 / 27% = EUR 453 billion

And thus for all banks in Europe the capital shortfall would be approximately 1.5 trillion!

Remember that my calculation may be an understatement of the true shortfall under a 20% CET1 capital requirement because:

  1. David Miles is speaking about equity (Tier 1 capital), and I used the shortfall for the total capital shortfall plus conservation buffer plus surcharge for G-Sib (total capital = Tier 1 capital + Tier 2 capital).
  2. Furthermore, some banks may already have a Basel III total capital of 8.0% plus a capital conservation buffer of 2.5%, thus understating the shortfall of capital / 1% increase in CET1 capital requirement.
  3. The RWA may increase over time with decreasing ratings of sovereign and corporate debts by rating agencies and the apparition of Credit Valuation Adjustment.
  • 2nd way to estimate the capital shortfall with public information

On the ECB website, one may find the consolidated banking data (source).

According to this excel files (I took the one for June 2012 for consistency), the total assets of domestic banks of the sample for EU-27 is equal to EUR 36,915 billion. For comparison purpose, the GDP was approximately EUR 13 trillion for 2012 (source). This means that domestic bank assets / GDP = 285%. If we include the foreign bank assets this ratio rises to 325%.

Considering that the RWA is approximately 1/2 to 1/3 of total assets, CET1 ratio equal to 20% of RWA is approximately equal to a CET1 / total assets of 8%.

Knowing that the CET1 / total assets (Basel III leverage ratio) is in average 3% for group 1 and 3.6% for group 2 (source), we may approximate the average Basel III leverage ratio by 3.3%.

If we want to arrive at a Basel III leverage ratio of 8.0%, knowing that total assets is EUR 36,915 billion, we would have to recapitalize the banking system by:

36,915 x (8.0% - 3.3%) = EUR 1,735 billion.

As a point of reference, according to the file of the ECB, the sum of profits aggregated after tax & prior to distributions between January 1st 2012 and June 30th 2012 was EUR 24.6 billion for all domestic banks.

Remember that my calculation may be an understatement of the true shortfall under a 20% CET1 capital requirement because:

  1. I used the total assets of domestic banks. The total assets of banks including foreign banks are EUR 42,220 billion.
  2. Some banks are more capitalized than others. One cannot take the capital of one bank to put it in another in order to have all banks with an exact leverage ratio of 8%.

What would be the capital shortfall of European banking system to comply with a leverage ratio equal to 15% of total assets?

  • Estimation of the capital shortfall with public information for a Basel III leverage ratio of 15%

Knowing that the total assets of domestic banks of the sample for EU-27 is equal to EUR 36,915 billion and that the average CET1 / assets (Basel III leverage ratio) may be approximated by 3.3%, in order to comply with a 15% Basel III leverage ratio, banks ought to find :

36,915 x (15% - 3.3%) = EUR 4,319 billion...

  • Estimation of the capital shortfall with public information for a leverage ratio of 15%

If we consider equity instead of CET1, knowing that the ratio of equity / total assets was 5.04% as of June 2012 according to the consolidated banking data of the ECB.

36,915 x (15% - 5.04%) = EUR 3,677 billion

EUR 4 trillion would represent approximately 30% of Europe's GDP.

But at least, now, you understand why policy makers / regulators will never try to implement a 15% leverage ratio: it would be impossible to implement without a haircut, money printing or a conversion of debt into equity...

Only an estimation

This is only an estimation of capital shortfall under scenarios that regulators will never implement on the short term and may never implement although on the long term.

This article is not intended to calculate a true capital shortfall, but to make people think about the undercapitalization of the European banking system that leads to the risks of accounting gimmickry in order to gain time (ESM founded by debt, lend in part by the banking system to the European governments since they are running deficits, and used to recapitalize weak banks), to haircuts (like in Greece or Cyprus), defaults & deflation or to their opposite, monetization of the debt and high/hyper-inflation... This analysis of course could be extended to other parts of the world.

In this context what could be a good strategy to protect capital and profit from the uncertainty?

Of course, you understand where I want to arrive. Get your money out of the banking system. When you buy a stock, be sure that your bank will not loan your shares to shorter without notifying you.

The best substitute to deposit (which is considered by many as money) is Gold (GLD) or Silver (SLV). With the current ratio Gold/Silver near 50 and knowing that the total amount of Gold mined over history is estimated at 170 000 tons and that the total amount of silver mined is estimated at 530 000 tons (source). Thus the ratio of scarcity is 3.12 ounce of silver for one ounce of gold, and silver may be clearly underpriced and more desirable.

To say the true, I view physical precious metals as money (because it bears no credit risk) and deposit as a loan to your bank (and thus it bears some credit risk).

So you may do the following: put your money in a basket of physical precious metals (overweight silver) and use options to expose yourself to the banking system.

You may for instance buy long-term out-of the money call option on the strongest banks (capital ratio and brand name / reputation) and buy long-term out of the money put options on the weaker banks (for instance Deutsche Bank (DB) may be a good target : if this article has enough success, I may write an article to justify my choice).

The reasoning is the following:

  1. The ECB will maintain low interest rates over several years in order to help the banking system to improve their capital and avoid deflation. Thus you may expect a boosting of profits during this period and an increase in the share price. Your call option may become at the money before the maturity.
  2. The ESM will recapitalize the weaker banks and there will be a dilution of capital. Thus your put option may become at the money before the maturity.

To put in a nutshell, you are benefiting in case of a worsening or improvement of the banking system and in the worst case you lose only the low premium paid for the out-of-money options...

You although protect your capital against a taxation (Cyprus scenario of deposit haircut). Moreover you are betting on the long term on the demise of the fiat paper money system and on the demise of fractional reserve of precious metals.

Source: European Banking System Undercapitalized By 1.5 Trillion Euros, With A Conservative CET1 Ratio

Additional disclosure: I am long out of the money call options on Societe Generale and BNP for EUR 500. I am currently thinking to sell my options on Societe Generale and buy put options on Deutsche Bank during the month of September.