Reuters has an interesting Interactive Eurozone Bank Stress Test

Adjust the Tier 1 Capital Ratio and Sliders for Haircuts and out pops an answer. This is what I came up with. It is hard to get the sliders to stop exactly on the spot you want.

A Political Problem?

Please consider Franco-Prussian flaw

The barriers to a proper recapitalisation of Europe’s banks look political, not economic. That’s the conclusion of Reuters Breakingviews’ latest bank stress test, which analyses what would happen if governments have to fill the entire capital hole required to restore confidence in Europe’s financial system.

The shortfall created by a tougher stress test is certainly large. Take the 90 banks that participated in the European Banking Authority’s now-discredited exam in July. If banks were forced to mark their sovereign debt to market and achieve a core Tier 1 capital ratio of at least 7 percent under a stressed scenario, they would need 93 billion euros. Raise the pass mark to 9 percent, and the hole is 260 billion euros.

That’s a giant leap from the gap of 2.5 billion euros identified by the EBA in July. However, when judged against the economies of the 21 countries whose banks sat the test, it’s still manageable. A 93 billion euro capital injection is equivalent to only 0.7 percent of the countries’ expected GDP for 2011. Even with a 9 percent pass mark, the bill is still just 2 percent of GDP.

Peripheral states would still suffer. At a 7 percent pass mark, Greek and Cypriot banks would need a combined 36 billion euros of extra capital. Footing the bill would push Greece’s 2011 debt-to-GDP ratio to 171 percent, from 157 percent. Cyprus’ post-recap debt would be 86 percent of GDP, 26 percentage points higher than before. But both those countries’ banking systems always needed help to cope with a Greek default.

The real question is whether Spain and Italy, which face a combined bill of 22 billion euros, need bailout money as well. However, financing the recap will only add 1 percent to their respective debt-to-GDP levels.

France and Germany have recently squabbled about whether the recapitalisation of their banks should be financed by the countries themselves, or by the European Financial Stability Facility. With self-help perfectly plausible, it suggests the real problem is justifying further bank rescues to voters.

The Problem is Political

I came up with a shortfall of 557 billion Euros. I suspect the answer is a lot more, say one trillion euros (not counting real estate loans, personal debt, and corporate debt writeoffs). However, there is absolutely no political will to allow that to happen, except via extend-and-pretend.

The problem is indeed political. The bondholders (that means banks), not taxpayers need to take those losses. Politicians (led by Nicolas Sarkozy) refuse to accept that.

Yet, the market will force it one way or another. The preferred way would be for banks to take a huge up front hit, right here, right now. The slow, painful way would be to stretch this mess out for decades like Japan did.

Politicians always want to avoid up-front pain. They will opt for slow-and-painful, no matter what the amount is. However, as I have said Eventually, Will Come a Time When ….

Eventually, there will come a time when a populist office-seeker will stand before the voters, hold up a copy of the EU treaty and (correctly) declare all the “bail out” debt foisted on their country to be null and void. That person will be elected.

Mike “Mish” Shedlock
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