The most important thing for Europe’s banks is clearly a solution to the sovereign debt crisis. A complete breakup of the euro would be catastrophic for most of the region’s large banks, while significant writedowns of peripheral nations’ debt would require them to raise more capital than the EUR 115 billion suggested in the stress tests conducted by the European Bankers’ Association (EBA). However, even in the seemingly unlikely case that a comprehensive solution to the sovereign crisis is found, the changed regulatory backdrop is a major challenge for the banks, and probably for the economy as a whole.

The funding bill

While there have been many iterations of the regulatory process in the last two years, we do now have some clarity on the extent of the changes. Even before the advent of Basel III, capital ratios in the major developed economies (US, eurozone, Japan, UK and Switzerland) had risen about 25% between 2007 and 2010. At the same time banks had raised their liquidity (in the form of cash and government securities) from 14% of risk weighted assets to 20%.

Basel III capital requirements are now largely decided and raise both the quality and quantity of core equity. In total this means that some USD 1.8 trillion of equity needs to be raised in the above countries to reach the new 7% minimum Core Tier 1 requirement. Most of this equity will come from retained earnings, but USD 240 billion will come from new issuance. This is, however, a minimum, and national additions and surcharges for systemically important financial institutions (SIFIs) will be mandated on top, meaning a rough average of 9% Core Tier 1 capital will be needed by most major global banks.

Liquidity ratios are the other major Basel III change being introduced between 2015 and 2018, with the Liquidity Coverage Ratio, measuring the ability to withstand periods of liquidity stress, and the Net Stable Funding Ratio, promoting more medium and long-term funding of assets. These measures will require some USD 830 billion of net debt funding by 2015 and USD 1.5 trillion by 2020.

The price of reform

The intention of reform is clearly to protect economies from severe financial crises and thus lost output. Official studies tend to conclude that the shorter-term costs will be manageable, with only minor effects on GDP. However, there is an assumption that the very large amounts of funding required will be forthcoming from the private sector at reasonable prices. This is based upon the premise that a better capitalised banking sector has a lower cost of funding. However, even if a solution is reached to the sovereign crisis, investors are still likely to be wary of the banks.

For equity investors, the fact that most of the sector’s earnings will be retained to build capital is one reason for caution. Then, there is the fact that equity is only one of the three buffers a bank has, and is arguably not the best. The other two buffers are strong capital generation (the best) and reserves. Furthermore, the cost of equity is also likely to remain high because of a large supply of shares being issued, poor profitability due to persistently low interest rates, and the risk of further regulatory shocks. If there was an element of anti-cyclical reserving in the place of very high capital ratios, investors might be happier. This would have a positive effect on ROEs and reduce the likelihood of losses in a bad debt cycle (and thus dilutive recapitalisation).

Nor are things much rosier for bond investors. Average global spreads on bank debt have risen over 100bps in the past four years and the market for long-term debt in Europe is currently in a state of paralysis. Clearly, an easing of the sovereign crisis would be helpful, but investors will still be wary, as plans are being developed to allow for ‘bail-ins’ of more bond investors, such that their holdings are converted to equity at times of stress. Furthermore, the market will have to bear large net new issuance, given the requirements of the new liquidity ratios.

Impact of deleveraging

With the raised cost of both equity and bond funding, banks are in a position where they need to raise spreads, delever and cut costs to protect returns. An Institute of International Finance impact study on banking regulations predicts that bank lending rates in the aforementioned mature economies will rise by an average 364bps between 2011 and 2015 and 281 bps between 2011 and 2020. The study also expects loan growth to be about three-tofive percentage points less than nominal GDP in these countries, while forecasting the level of GDP will be 3.2% lower than it would otherwise be in five years time.

The confluence of EBA sovereign stress tests, closed unsecured bond markets and Basel-related deleveraging have become the focus of increased concerns in Europe over the last few weeks, as has a deteriorating lending officers’ survey in October. UBS is now estimating that 11-13% of eurozone bank assets will be shed in the next three years (including EUR1.4-1.7 trillion of loans). If the right policy actions are not taken (first and foremost guarantees on unsecured bank bonds) then the prediction of a mild 0.7% economic contraction in 2012 could prove to be the best case scenario.