Wednesday, October 26, 2011

Needed: An alternative to European banks starting credit crunch to meet capital requirements when they cannot raise new equity

It is becoming clear that Eurozone banks are going to be required to a) write down the value of their assets - say Greek debt to 30% of par and b) increase their Tier 1 capital to 9%.

According to the European Banking Authority, this will require Eurozone banks to raise 108 billion euros in fresh capital.

The problem with raising new capital is twofold.  First, none of the banks want to sell stock at today's price because it will be dilutive to existing holders.  Second, no investor believes that 108 billion euros is adequate - Credit Suisse estimated 400 billion euros, Goldman estimate 1 trillion euros and BlackRock's Larry Fink estimated 2 trillion euros were needed.

As an alternative to raising this capital, Eurozone banks can instead sell assets and not renew existing loans as they mature.  The problem with this approach is that it sets off a negative spiral of credit crunch leads to recession leads to more problem loans leads to more write offs leads to more capital needed leads to further credit crunch....

There is a desperate need for an alternative to effectively forcing the Eurozone banks into starting a credit crunch.

This alternative is to trade off disclosure for higher capital.

Specifically, rather than increase their Tier 1 capital to 9%, banks can instead make available to market participants their current asset and liability detail.

With this data, market participants will be able to a) assess the true risk of the bank, b) monitor this risk and c) enforce market discipline which should discourage the bank from increasing its risk profile.

Perhaps more importantly, the issue of bank solvency is put behind each of the disclosing banks.

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