European Banks & The Grand Solution :: Stress Testing the Banks::Citi,

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European Banks & The Grand Solution
Stress Testing the Banks, Part 3
 Progress Towards Bank Recap — Work on a “comprehensive” solution to the
European sovereign crises appears to be gathering momentum. EC President
Barroso's speech yesterday highlighted a coordinated recap of the European banking
system as well as proposals to increase the EFSF’s firepower, accelerating the ESM to
2012 (from 2013), as well as more integrated economic governance.
 Stress Tests Part III — Mr. Barroso’s plan calls for banks to be recapitalised
“temporarily [to] significantly higher capital ratios of highest quality capital”; press
reports suggested that the benchmark for EBA stress tests could range at 7-9%. We
believe that the stress tests could also include sovereign exposures held within the
Banking book (not just the Trading book).
 €64-€216bn Core Capital Shortfall, or Less?— We estimate a core capital shortfall
for the EU banks included in the stress tests of €64-216bn, for a minimum CET1
requirement of 7-9% respectively; this represents c1-2% of GDP. Marking-to-market
(rather than stressing) sovereign exposure would reduce capital requirements by c€20-
40bn. Using the “baseline earnings” would represent a further c€150bn improvement.
 Raising Capital, Restricting Dividends — For banks with a shortfall, Mr. Barroso
proposes they first tap private sources of capital; followed by national government
support, backed by loans from the EFSF where necessary. We expect the widespread
involvement of public capital. Banks requiring public capital injections would face
temporary restrictions on dividends (and potentially on staff rewards).
 Devil in the Ddetail? — Hopes of a "comprehensive" solution to the eurozone crisis,
including bank recapitalisation, have been rewarded by equity markets in recent days.
However, the devil is in the detail and a lot is still unknown: the target capital level, the
type of capital (preference shares or common equity?); the timescale banks will be
afforded to raise their capital ratios, the extent of restrictions on dividend payments
(and T1/T2 capital coupons) and even more importantly, the nature and scale (end
effectiveness) of the liquidity backstop and EFSF firepower.
 Next Steps — The EU summit scheduled for 17-18 October has been pushed back to
23 October, ahead of the G-20 meetings on 3-4 November, to allow time to "finalise our
comprehensive strategy on the euro-area sovereign debt crisis” (EU President Van
Rompuy). The increasing anticipation is for Franco-German accord on bank
recapitalisation plans by the postponed summit.
 Don’t Forget The Sovereign — While a bank recap may provide additional confidence
to funding markets, we believe this is not an alternative to addressing the 'core' issue –
namely providing a credible sovereign liquidity backstop and, over time, creating an
integrated governance system for the EU to support the shift towards greater debt
sustainability.