This is the subject of fierce discussions nowadays. My view is that they are, and by a significant margin.
Capital is the ultimate cushion to absorb unexpected losses and to inspire confidence from market counterparties and customers. In other words, carrying sufficient capital is an essential element of risk management and a cost of doing business. Banks and their critics have argued that other elements need be considered as well, such as funding, customer profiles and reserve policies.
All of this is true. European banks, by and large, rely more on wholesale funding than their US
Perhaps the most telling indicator that European banks are undercapitalized is the fact that their risk weighted assets, against which they need to carry capital, represent a much lower proportion of total assets than they do at American banks.
To illustrate this point, we have selected four of the largest and best European and American banks. Both European and American exponents include one bank with strong exposure to investment banking and one with a greater exposure to traditional commercial banking. They are JP Morgan (JPM) and Wells Fargo (WFC) on one side of the Atlantic and BNP Paribas (BNP) and Deutsche Bank (DB) on the other. For the European banks, we have also used their adjusted total asset numbers, meaning as reduced by netting out derivatives positions.
The results are eye opening:
JPM at 9/30 | WFC at 9/30 | BNP at 6/30 | DB at 6/30 | |
Total adjusted assets | $2,289 | $1,305 | $2,175 | $1,750 |
Risk weighted assets per | $1,221 | $982 | $863 | $464 |
Ratio of TA/RWA | 53% | 75% | 40% | 27% |
Let me reiterate that all four banks are presenting their financial results in accordance with the rules and regulations applicable to them. I would also note that Wells Fargo is the closest to traditional banking, so that it makes sense that it has the highest TA/RWA ratio. But recent history has shown that there is no such thing as a riskless financial asset. Based on this observation, BNP and DB carry much less capital in relation to their total assets than JPM and WFC, and they are more exposed to a riskless asset, like a sovereign bond, suddenly becoming "risky" and therefore deserving of a capital cushion.
From a common sense point of view, I submit that it is less risky to make relatively small loans to millions of customers who have checking and savings accounts with you than to hold billions in sovereign bonds or to extend billions in credit lines to banks whose actual risk profile is known, if at all, only to their management.
This is not to say that European banks should be demonized or punished. It is close to impossible for major banks not to hold bonds from their own governments, and the dicier public finances get, the greater the pressure heaped on them to increase these holdings. It is also understandable that, as the European Union developed and matured, they would want to expand their operations in neighboring countries. Italy
In that sense, these banks were not guilty of gross misbehavior, like making loans to borrowers who could not afford to pay current interest. I can sympathize with European CEOs who clamor for their countries to get their act together and shore up their budgets and public borrowing needs.
But at the end of the day, counterparties and customers will determine the profitability and even the fate of European banks, or at least of their management and shareholders. In this regards, European banks have been too cute, relying on rules that were too good to be true. Perhaps because they enjoy much closer rapport with their governments than American ones do, they have forgotten that markets can quickly get unforgiving and ignore the best Power Point presentations.
With some exceptions, European banks need to raise fresh capital, now.
