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In Europe,

On average the 31 companies in the Euro Stoxx Banks Index (SX7E) trade for 39 percent of common equity, or book value, according to data compiled by Bloomberg. France’s Credit Agricole SA (OTCPK:CRARY) trades for 23 percent of book. Yet somehow the European Banking Authority last month concluded it had no capital shortfall.

The situation in the U. S. is better, but not good. Bank of America Corp. (NYSE:BAC), for example, trades for 33 percent of book and insists it doesn’t need to sell new common shares, in spite of the markets’ contrary verdict. (Bloomberg article.)

“Zombie” banks are banks that have substantial amounts of worthless assets on their balance sheets but are afraid to write them down. In essence, the financial markets are doing the “writing down” for them.

Bankers are reluctant to write down assets in the first place. First of all it is an admission of a failure -- of underwriting, of intuition, of forecasting, of lax behavior. The bankers that are holding your deposits don’t like to admit that they have made a mistake.

I know this is true; I have completed three (successful) bank turnarounds in my career, so I have seen the other side of the asset acquisition process in commercial banks.

Furthermore, bankers don’t like to write down assets way after the time in which they should have written them down.

Bad assets accumulate and the longer that bankers “paper over” their bad asset problems, the more the problems tend to grow and “the eventual clean up” becomes even worse. Rather than admitting that a problem exists and allocating resources to clean up the problem at an early stage, the bankers postpone devoting enough effort to resolving these issues and, in consequence, they find that the difficulties of their job increases in a non-linear fashion as the number and complexity of bad assets grow and multiply.

The problem now is that most of these “zombie” banks want to raise more capital to satisfy the new, higher regulatory requirements for capital but find that their stock prices are so depressed that raising additional capital can be extraordinarily expensive.

The author of the Bloomberg piece, Jonathan Weil, discusses this in the above quoted article. He focuses on UniCredit (OTC:UNCIF), the Italian bank that took a large writedown in the third quarter of 2011, which resulted in a 10.6 billion euro loss. On top of this the European Banking Authority determined, after the latest stress tests, that UniCredit had an 8 billion euro capital shortfall.

As of September 30, 2011, UniCredit had 950 billion euros in assets and only 52.3 billion in euros in common shareholder equity on its balance sheet. The stock market value of the bank is 14.8 billion euros. Something doesn’t add up here.

And that is where the concern over the other European (and American) banks comes in.

With bank valuations in the range of those mentioned in the first two paragraphs of this post, the financial markets seem to be indicating that many of these banks have substantial amounts of questionable assets on their books that they have failed to publically acknowledge. This is one of the problems financial markets face: if the institutions they invest in are not brave enough -- nor honest enough -- to reveal this to the marketplace, then investors just have to guess at how serious the problems are.

In times like these, the guesses will tend to be on the negative side. This certainly doesn’t help the bankers to raise the capital they need to get back onto a solid capital footing.

Are there still a lot of “zombie” banks “out there”?

I believe there are. Although the FDIC only closed 92 banks in calendar year 2011, the number of banks in the United States shrunk by more than double this number. In the third quarter alone, only 26 banks were closed yet a total of 61 banks left the banking system. While the number of banks closed in the 12-month period ending September 30 was around 100 in number, the banking system had 271 fewer banks. So for 2011 it seems as if the number of banks leaving the banking system were two to three times the number of banks that the FDIC actually closed.

There was cheering when the number of banks listed on the FDIC’s problem list fell in the third quarter to 844 banks, down from 865 banks the quarter before. But this means that although the problem list dropped by 21 banks, 61 banks -- most of them troubled in one way or another -- dropped out, which means that maybe around 40 new problem banks got added to the FDIC’s list. (For more on this see my post While Small Banks Disappear, Big Banks Get Bigger.)

My point here is that I don’t believe that either Europe or the United States is finished with its banking problems.

I still contend that one of the major reasons that he Federal Reserve pumped so much money into the banking system was to keep banks liquid enough so that they didn’t have to write off bad assets at too fast a pace, so that the banks had more time to try and work out these bad assets, and so that the FDIC had sufficient time to either close these banks as smoothly as possible or arrange for acquisitions to eliminate a substantial number of the “bad” banks.

Sooner or later, however, the bad assets on the balance sheets of banks are going to have to be recognized.

The problem is still sufficiently severe that these “zombie” banks are unwilling to admit to the world that they remain troubled. For a more realistic valuation of their assets we will just have to look at market values.

These banks are not out of the woods yes, for in Europe the “next” recession seems to be in progress. How this recession will play in the United States is, of course, unknown. (See my post, Issue Number 1 For 2012 Recession In Europe.)

How much better it would have been for these banks to recognize and claim these bad assets earlier and to have fully disclosed them and then set out to work to correct the situation than to postpone recognition and paper over the problems which, in the end, creates major difficulties.

Bankers vociferously fight mark-to-market accounting and the timely writing down of “worthless assets” after-the-fact, that is, after the damage has been done. The problem is that mark-to-market accounting and the timely writing down of “worthless assets” are aimed at getting bankers to do their jobs before the financial crisis occurs. The hope is that the early proper recognition of the problems will lead to earlier resolution of them thereby avoiding major cumulative collapses.

Source: There Are Still 'Zombie Banks' Around