Groundhog Day

As in the film Groundhog Day, the euro zone seems trapped in a nightmare whereby it is constantly waking up and having to address the very problems it believes it has already taken the necessary measures to resolve. The possibility that the European Banking Authority (EBA) will increase the capital requirements of European banks from five percent to nine percent in stress tests from now on has created a new set of challenges for the sector, reflected in the fall in bank shares throughout Europe on Thursday.

The demands of the heads of the European Commission and the European Central Bank, José Manuel Durão Barroso and Jean-Claude Trichet respectively, that EU banks recapitalize to cover the deterioration in the quality of their assets brought about by the Greek crisis have set off panic in the sector.

Barroso is partially right. He shows a clear understanding of the situation when he says that lenders who are unable to meet the new minimum capital requirements should be banned from paying bonuses and dividends. That said, it is probably more accurate to say that payment of such bonuses and dividends should be decided by the regulators of each country.

The problem with his call for "urgent recapitalization" is that it makes no distinction between lenders that might face difficulties, for example those holding Greek debt, and those facing different, albeit equally serious problems such as a lack of profitability or access to credit. For these banks new capital requirements would simply mean having to tie up more of their cash, thus reducing their ability to lend yet further. What's more, they will find it hard to attract new capital in the markets to boost their balance sheets; not even within the three months that the Commission is proposing allowing them. By having to resort again to the capital markets, they are in effect accepting the counter-logic of seeking help from the very source of the crisis that they are attempting to correct.

The most likely outcome of the EBA's new requirements will be that more banks will fail the stress tests, and that Barroso's proposals will only be met by new injections of public money into the banking system. In which case, our governments should make sure that any bank using public money should make room for government-appointed members on their boards, and for them to have decision-making powers.

Barroso and Trichet are right to be worried, but their concerns will not be addressed simply by tightening the screw on banks by requiring them to find more money. The question has to be addressed on a case by case basis, depending on individual banks' assets, their problems, and the amount of capitalization that can reasonably be demanded of them in the context of the problems they face.

It must surely come as no surprise that France, Germany and Spain have reacted negatively to Barroso and the EBA's plans. What's more, while recapitalization is urgently needed, it will solve nothing until a definitive solution is found to Greece's problems, as well as to the question of risk premiums. It makes no difference how much money is pumped into a bank when its assets can be wiped out by a bad day on the debt markets, in turn requiring further capitalization, and on and on ad infinitum.