Bloomberg: Europe’s capital shortfall

Bloomberg View Editorial Board

Less than a decade after the financial crisis, Deutsche Bank is in trouble again, with investors speculating about whether the German government will have to rescue one of the world’s largest financial institutions. The sad thing is how easily this predicament could have been avoided.

This time around, Deutsche Bank is not dealing with an unforeseen market meltdown or sovereign-debt crisis. Rather, the proximate cause of distress is the U.S. Justice Department’s threat to fine the firm US$14 billion for decade-old transgressions involving U.S. mortgage-backed securities – more than double what the bank has set aside to cover such legal costs. Concerns about capital adequacy have sent the stock price to record lows, and the German government says it will not provide a financial safety net.

The episode illustrates Europe’s failure to learn an important lesson from the last crisis: The largest banks must have plenty of loss-absorbing equity capital, so that even after suffering a hit, their balance sheets are strong. Otherwise, governments risk finding themselves choosing between a taxpayer-backed rescue and the potentially devastating repercussions of letting a systemically important financial institution go bust.

Instead of using the post-crisis years to build up irreproachable equity capital buffers, however, European banks have given back hundreds of billions of euros to shareholders in the form of dividends and share repurchases. From 2009 through 2015, Deutsche Bank paid out about 5 billion euros in dividends, a significant chunk of the 19 billion in equity it raised. Today it is among the most thinly capitalized banks in Europe, with tangible equity amounting to less than 3 percent of assets – an astonishingly thin layer.

Even if Germany genuinely wanted to let Deutsche Bank fail, it could not credibly threaten to do so. The institution is arguably Europe’s most systemically risky, with assets amounting to more than half of Germany’s total annual gross domestic product. Making an example of Deutsche Bank could lead to a devastating contagion.

Instead, Europe’s leaders – and particularly the European Central Bank, which oversees the euro area’s largest institutions – must drive the process of recapitalization. That means performing stress tests that reveal the true scale of banks’ needs, figuring out which institutions can and should be allowed to fail, and providing public funds to shore up the rest if necessary. If authorities can show enough resolve to inspire market confidence, the region’s banks may yet be able to raise the equity they need from private investors (as U.S. banks did in 2009).

The euro region desperately needs better-capitalized banks. If the near-death experience of one of the world’s largest institutions cannot spur European officials to action, it’s hard to imagine what could.

© 2016, Bloomberg View