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In the second round of the ECB's LTRO operation, banks borrowed about half a trillion euros, taking the total after two rounds to about a trillion euros. These operations have brought strong criticism from Jens Weidmann, head of the Bundesbank, as well as other traditional European central bankers. These negative voices (now almost ritual) predict renewed difficulties when the three-year loans mature. How will the banks fund the repayment? Will the ECB be forced to extend the extraordinary credits? Where does it all end?

These critics do not see the bigger picture of Mr. Draghi's strategy. I discussed that strategy at greater length here. The important point for today -- immediately following the successful LTRO tender -- is that the LTRO provides a three-year window of breathing space in which European banks will be forced to build up their capital to meet new Basel and EU standards.

The fundamental reason that European banks have needed central bank funding has been that with inadequate capital, no one else will lend to them. Institutions all over the globe will lend to banks with strong capital positions but not to banks with weak capital. Over the next three years, European banks are going shrink their assets and increase their equity capital in order to be in compliance with the new standards.

Mr. Draghi will be in the forefront of the EU movement to make certain that banks accomplish this transformation. At the end of the process, European banks will be strong enough to stand on their own for the first time in many years. Banks that cannot make the transition will be forced to merge.

Shareholders of European banks can rejoice that reform is being forced on them. But shareholders also should be aware that (1) reducing assets often requires selling profitable businesses, (2) banking is an asset game in that earnings are based on the volume of assets as well as their profitability, and (3) raising capital is highly likely to result in significant dilution, as already has occurred quite prominently at Italy's Unicredit (OTCPK:UNCFF).

It seems likely, based on these likely reductions in earning power per outstanding share, that most European banks are in fact worth less than their book value per share at this time. How much less has to be evaluated in each case by estimating how much earning power they will have to give up and how much additional equity capital they will have to raise.

Perhaps the market already has priced in these factors, since major banks like Deutsche (NYSE:DB), Credit Agricole (OTCPK:CRARY), and Societe Generale (OTCPK:SCGLY) are trading at prices to book value of 62%, 26% and 21%, respectively (estimates from Yahoo Finance). If the French banks really are going to be able to comply with the new capital requirements without government assistance, then their low valuations may make them attractive investments. And Deutsche, Germany's flagship bank, may be a good investment, as well. The risks obviously are significant, but they appear more manageable than they did six months ago.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Investing In European Banks: Low Valuations Vs. Capital Requirements