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Europe has itself to blame for bank sell-off

November 21, 2011: 9:08 AM ET

European regulators wanted their banks to raise their capital ratios, but they didn't expect them to do it by dumping assets.

By Charles P. Wallace, contributor

FORTUNE -- The selling spree currently swirling through the European debt markets, which regulators worry may spread to U.S. banks, was caused in large part by a series of policy gaffes by European regulators and banking authorities.

On Oct. 26, the European Union's leadership agreed to force banks to raise their capital to asset ratios from 5% to 9%. The assumption was that Europe's 70 largest banks would get new money from investors or forego dividends, thereby restoring confidence to the financial system. But the decision left open another possibility: dumping assets, which is exactly what major banks appear to be doing.

For instance, BNP Paribas, which is France's largest bank by assets, announced on Nov. 3 that it had sold off 24 billion euros ($32 billion) worth of sovereign bonds. "We very much reduced our exposure to sovereign debt," BNP Paribas CEO Baudoin Prot said in a Bloomberg television interview, acknowledging that the demand for new capital was the cause for the speeding up of the process. Among the sold items: $11 billion of Italian government bonds. The bank said it expected to lose more than $1.3 billion on the asset sales.

The trouble with France

Societe Generale and Germany's Commerzbank have also announced sell-offs of their sovereign debt, and it is believed many other institutions are quietly dumping their Italian bonds.

"This was a big mistake," says Benn Steil, director of international economics at the Council on Foreign Relations in New York. "The banks looked at what it would cost to raise capital and they said that's prohibitive. They have been quite clear about their response: they are going to shed assets."

Charles H. Dallara, managing director of the Institute of International Finance, which is representing 450 banks in their negotiations with Greece, warned European leaders that the recapitalization plan would cause serious problems. "The market value of the debt of the countries most under scrutiny is likely to decline further as banks unload sovereign bonds," Dallara wrote in a letter to G20 leaders meeting in France.

Lessons from the U.S.

The fear is that with all of Europe's banks struggling to reach their new capital limits, they will dump the least valuable assets first. Those happen to be government bonds issued by Italy, where interest rates have topped 7%, forcing the new government of Prime Minister Mario Monti to adopt a severe austerity program in a hurry. Now the concern is that the falling value of Italian bonds will destabilize banks in other nations, such as France. That could lead to French bonds losing some of their value, in a never-ending "death spiral," as one analyst termed it.

Steil says Europe should have learned from former Treasury Secretary Henry Paulson, who on October 13, 2008 called in the CEOs of the nine largest U.S. banks and told them they had no choice but to agree to an infusion of government capital.  He had them sign pledge cards agreeing to take the money.

Paulson's approach worked, Steil says, because it didn't allow the banks any alternative but to take the money. Europe's banks, on the other hand, have until June 2012 to adjust their capital ratios.

"They should have done it right away on Oct. 26 and not waited nine months," says Karel Lannoo, head of the financial markets unit at the Center for European Policy Studies in Brussels. "In the meantime, the damage will be done."

Why Germany needs the euro

Another policy mistake Lannoo cites is the statement by Mario Draghi, the new president of the European Central Bank, that the ECB would not be a lender of last resort to foundering countries like Italy.

"This was the biggest stupidity you could have," Lannoo says. It sent a message to the markets that the ECB would buy some Italian bonds on the open market, but only a limited amount. Bankers concluded that they should sell immediately before the ECB changed its mind, triggering a stampede to the exits.

The ECB is currently split politically over whether to continue buying sovereign debt of struggling European nations in order to keep interest rates at reasonable levels.

The Germans, in particular, are against it. Jens Weidmann, the president of the German central bank, said the ECB can't lend to sovereign governments because it would violate the treaty establishing the European Union. "I cannot see how you can ensure the stability off a monetary union by violating its legal provisions," Weidmann told the Financial Times.

Lannoo also faults the European Banking Authority for continuing to assign zero risk weight to sovereign bonds, even though everyone knows countries like Greece and Portugal can't pay their debts and the banks will not get fully repaid. Under the European rules, if a bank owns a government bond from Europe, it doesn't have to hold capital against it. So many banks loaded up on their own country's debt.

It's created a weird dichotomy in Europe: banks that gorged on sovereign debt, particularly in France and Germany, are considered the most creditworthy, while banks in Spain, which lent money to the private sector and thoughtfully diversified their business to Latin America, are considered risky, which forces them to raise the most capital. The most absurd example is Spanish bank Banco Santander, which most analysts consider one of the best-run banks in Europe. But under the new rules, Santander must raise $9 billion in new capital.

"They are just furious in Spain," Lannoo says. "If you want to encourage banks to lend to enterprise then you don't penalize them for having higher risk assets."

Nicolas Véron, senior fellow for financial regulation at Bruegel, a Bruseels-based think-tank, says the problem of recapitalizing the banks was exacerbated by the fact that many national governments were reluctant to inject cash into their banks because they lack funds.

"It's an impossible equation," Véron says. "Member states don't want to nationalize their banks, but the marketplace is not ready to provide huge capital infusions. Therefore the fallback position is deleveraging, which is clearly not great economically and may be actually very bad."

Véron says a European-wide fund is needed to recapitalize the banks, which should be offered some kind of asset swaps to bail them out. Otherwise, he says, the European crisis seems doomed to keep unraveling.

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