August 28, 2011 6:43 pm

Lagarde capital call surprises regulators

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Will Christine Lagarde’s call for Europe’s teetering banks to “urgently” shore up their capital levels spur a long-expected wave of cash calls across the sector?

The head of the International Monetary Fund provided one of the starkest warnings yet about the system’s fragility in Jackson Hole, Wyoming, on Saturday, effectively rejecting the results of last month’s pan-European bank “stress tests”, which found that the majority of the region’s big lenders were adequately capitalised.

But it was her statement that the “most efficient” solution would be some form of mandatory recapitalisation, potentially using the European Financial Stability Fund to make direct capital injections into the region’s weakest banks, that surprised regulators and European policymakers.

“Banks need urgent recapitalisation,” Ms Lagarde said. “They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis.”

Europe’s banks have faced calls to raise capital for months, amid pervasive concerns over the deepening sovereign debt crisis across southern Europe. But senior bankers and analysts say the much bigger concern hanging over the sector right now is liquidity, and banks’ ability to fund themselves in sharply deteriorating markets.

Société Générale, the French bank, was earlier this month forced to formally reject rumours that it was facing a funding crunch after its share price slumped 15 per cent in a single day. The cost of insuring European bank debt against default has reached all-time highs, in excess even of the days leading up to the financial crisis.

Investors remain sceptical that banks can withstand the losses of a default by a European government, and whether they would be able to cope with the accompanying disruption in the short-term funding market. According to a recent analysis by Morgan Stanley, bank funding has fallen off materially over the past three months, and the cost for banks is expected to be significantly higher when the markets reopen in September.

“Banks in some countries have had trouble securing liquidity in recent weeks and that pressure is going to mount,” said one central banker.

Some senior European officials also expressed surprise about the timing of Ms Lagarde’s comments over the weekend, arguing that banks have already made substantial progress in recapitalising themselves.

One senior official involved in discussions about the banks’ health noted the sector had raised about €60bn in capital through private markets during the first half of the year.

Although Brussels has pushed national governments to step up their preparations for recapitalising distressed banks, the official noted that the tests showed only a limited number of banks in need of shoring up. “The process Christine is referring to is already going on,” said the official.

Banks hit particularly hard by the recent turmoil and which are cited as the most likely to need recapitalising - such as Italy’s UniCredit and SocGen - are in better shape than they were four years ago. Both now have core tier one capital ratios of more than 9 per cent, compared with less than 6 per cent in 2007.

Last month’s stress tests, conducted under the auspices of the European Banking Authority, were designed to shore up confidence in the system by revealing the full extent of banks’ exposure to Greece, Ireland and other heavily indebted economies.

Only nine banks, however, “failed” those tests with a core tier one capital ratio – a key measure of financial strength – of less than 5 per cent. The total capital shortfall between those banks was just €2.5bn, leading several analysts to criticise the rigour of the EBA’s analysis, and in particular its failure to model the full impact of a Greek default.

The EBA has robustly defended its testing process, noting that in the absence of a swathe of capital raising over the first half of the year, 20 of the 91 banks tested would have failed, with a combined capital shortfall of close to €30bn.

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