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The focus of the investment community was recently fully aimed on the Italian banks. In just a few weeks time, we lived through the semi-failure of Banca Monti dei Paschi, the rescue of the bank (at least, for the next few months, as we wouldn’t be surprised to see the problems re-surface), and the nervousness surrounding the expected 13B EUR rights issue by Unicredit, a bank which is an even more vital link in the Italian banking sector.

Everything is unfolding rapidly, and it’s stunning to see how badly capitalized the European banks are. And obviously, the problems aren’t just situated in the periphery of Southern Europe. The mainstream media doesn’t seem to care to report on the new Basel IV capital requirements, and the negotiations surrounding these new capital rules.

There’s a very good reason why the national and supranational regulators have been able to agree to the final terms of the new capital requirements after negotiating for more than a year. Officially, the negotiations are still ‘ongoing’, but it’s not a huge secret the European banks and their American counterparties are heading towards a frontal collision.

The reason is very simple. In the past seven years since the Global Financial Crisis, the American banks have really done their best to get their acts together and the capital basis of most banks is very strong as most banks ‘saved’ their annual profits by adding them to the reserves, whilst the European Banks stubbornly continued to reward their shareholders by paying dividends and special dividends.

BAsel 1

Source: Blogfinance.bearingpoint.com

Now, several years later, it’s time to review the capital requirements of the banks as the Banking supervising system (in this case the Basel Committee, at the BIS, the Bank for International Settlements) wants to restore the credibility of the financial sector. Arguably, the best way to achieve this is proving to their clients, customers and investors the capital ratio’s will prevent another total failure in the banking sector.

The American financial institutions have been pushing to increase the risk levels of the mortgage loans. Right now, the models assign a credit risk of 35% to residential mortgage loans, but the Americans wanted to increase this ratio to 45% for loans with an LTV of 80% and higher, and to 55% of loans with an LTV of in excess of 90%. An uniform system would prevent banks from ‘messing’ with their balance sheet to make it look like they are effectively meeting the capital requirements (as they can obviously make their internal models say what they want it to say).

Basel 2

Source: ecestaticos.com

This would have a huge impact on several major European banks, as the perceived risk on  their mortgage portfolios would increase tremendously, requiring them to have 50% more capital available to meet the new capital ratio requirements. The Dutch, Belgian, Scandinavian and German banks would be hit the hardest, with ABN AMRO and ING Bank seeing their capital ratios fall to just 10% should they be required to boost their capital ratios.

And the biggest elephant in the room, Deutsche Bank, would be in deep trouble again, as independent estimates are pointing in the direction of a 125B EUR problem; as Deutsche Bank’s ‘risky assets’ would increase by just over 30%.

Basel 3

Source: marketrealist.net

This problem didn’t go unnoticed at all, and we aren’t the only ones who have identified this potentially huge problem. In a very recent research paper the Harvard International Law Review is shooting the Basel IV proposals down, calling it a ‘potential disruptive impact’ on the banking sector as banks will have to start hoarding more cash to ‘back’ the mortgage loans, which would reduce the banks’ willingness and ability to provide more credit to companies and other borrowers.

Basel 4

Source: strategyand.pwc.com

However, the fact the negotiations weren’t completed before the US elections in November might indicate a ‘softer’ approach is in the works. It would be surprising to see President Trump be a hardliner against banks (keep in mind several European banks are financing the mortgages on his buildings), and it will be interesting to see how ‘strict’ the Basel IV rules will turn out to be.

The total amount of Risk Weighed Assets could increase by 7T EUR. That’s right, 7,000 billion EUR. Good luck trying to fill that hole!

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