The capital shortage is global

Posted by on 30 April 2009

The capital shortage is global

Michael Pomerleano and Ying Lin
Until recently, the international financial community was focused on the financial crisis in the US, while the European and Asian banking communities indulged in a “Schadenfreude” at the misfortune of the US after years of envying the financial innovations in the US. However, the recent Global Financial Stability Report from the IMF points out that the banking crisis is global. Martin’s recent article reviews the data (Fixing bankrupt systems is just the beginning
In this context, it is instructive to analyze the condition of the various banking system in the world, and get a sense for the capital shortfalls. We estimate that the largest banking systems in the Europe have $2,438 billion in Tier 1 capital and a capital shortfall of $3,397; In East Asia, the largest banking systems have $1,189 billion in Tier 1 capital and a shortfall of $758 billion. The findings of this article are twofold. First, there is a global shortage of bank capital. Second, the largest share of bad assets belongs to European banks, and Europe has both the biggest capital shortfall and has made the least progress in restoring the banking system to health.

With Ying Lin’s invaluable assistance we analyzed the banking data provided by Bankscope ( ). There are three issues at least. The data is not as timely (2007 data) and not as comprehensive as one would expect. Second, due to differences in national regulatory regimes, as well as accounting, and taxation, the data on capital, equity and non-performing assets are not strictly comparable across countries. Third, not all the financial institutions report comprehensive data. Mostly state owned institutions do not report key variables such as assets, equity, non performing loans and reserves. Therefore, it took considerable effort to analyze the data. As a result the findings need to be interpreted with caution. Nevertheless the results are instructional.

In a previous column in the FT Economists' Forum (“Geithner and Summers need to address the banking problems square-on” ) my estimate of the capital shortfall in the US was $753 billion. The estimate is higher than the IMF’s estimate of $275 billion. However, the respective estimates are easily reconcilable. The IMF analysis aims for a ratio of tangible common equity to tangible assets of 4 percent, while my estimates maintain the nominal present Tier 1 ratio (and therefore by definition the same Tier 1 to risk weighted assets ratio, and tangible common equity to tangible assets), which is higher. In fact, under US federal bank regulatory agencies’ definitions, a bank holding company must have a leverage ratio of at least 5 percent to be well-capitalized. My calculations replace as well $296 billion in intangible equity (largely goodwill from acquisitions) with tangible equity. The IMF report notes that the capital shortfall doubles in order to reach the capitalization ratios of the 1990s. Evidently, we will know more about the capital shortfall in the U.S. after the Federal Reserve releases the results of the stress tests on the 19 largest U.S. banks on May 11, 2009.

What about the rest of the world? There is increasing recognition that the Eurozone has a serious banking problem. The Telegraph quotes a confidential memo prepared by the European Commission "The toxic debts of European banks risk overwhelming a number of EU governments and may pose a “systemic” danger to the broader EU banking system” .
Risk News reports that the German banking clean-up could involve €816bn of assets ( Finally, Bloomberg reports (April 23) that the U.K. government supports for the banking system has reached 1.4 Trillion Pounds ($2 trillion) and may climb higher as the financial crisis spreads to the building societies. (

The calculations of the capital shortfall countries in Europe, and in the next paragraph for Asia use unadventurous assumptions: A leverage ratio of Tier 1 capital to assets of 5 percent (To be well-capitalized under US federal bank regulatory agency definitions, a bank holding company must have a leverage ratio of at least 5 percent); non performing loans of 8 per cent of assets; and 100 percent coverage ratio of reserves to non-performing loans. According to reports of the Board of Governors of the US Federal Reserve System the delinquency rate for business and real estate loans reached 7% and 6% respectively in 1991 at all of commercial US banks. The largest banking systems in the Europe have $1,589 billion in Tier 1 capital and an estimated capital shortfall of $3,391bn. We estimate the largest Tier 1 shortfalls as follows: Germany –$559.8 billion; United Kingdom -$US719.4 billion; and France – $792.2 billion.

In East Asia, the largest banking systems have $1,189 billion in Tier 1 capital and a shortfall of $758 billion. We estimate the largest Tier 1 shortfalls as follows: Republic of Korea - $44.5 billion; Peoples Republic of China- $109.1 billion; and Japan - $518.8 billion. The banking systems of Japan and China account for 84 percent of Tier 1. For example, In Japan, the three biggest financial groups -- Mitsubishi UFJ, Sumitomo Mitsui and Mizuho in Japan are reported to have a capital cushion of $176 billion. However, according to Macquarie Research (Japan mega banks, 31 March 2009) the three mega banks are undercapitalized. The research report points out that the problem isn't quantity, but the quality of their capital. Macquarie’s analysis notes that a large chunk of that capital comes from sources that aren't permanent ( half of tier 1 is capital gains on Nikkei stocks or feature more as debt rather than equity), and that the banks capital ratios are low. Macquarie Research’s calculations of one broad measure of capital-- tangible common-equity to tangible assets – yield a ratio of 3.6 percent for Japanese banks, while European banks are at 4.2 percent, and in the U.S. -the epicenter of the banking crisis -- the ratio is 4.6 percent. In order to offset bad-loan losses and raise Tier-1 ratios to 6 or 8 percent, the banks will need to mobilize billions of capital. ( I realize that the findings are provocative and troubling, but they need to be in the public domain. Therefore I encourage analysts to use the Bankscope data and other data sources to prepare independent estimates to hold policy makers accountable.

There are several conclusions from this analysis. We can no longer focus solely on the US banking crisis. The banking crisis is global, with the European banking systems far more vulnerable than the US for several reasons. First, European banking systems are disproportionately large in countries such as Switzerland and the UK; and European banking systems have major exposures to emerging markets, primarily in Eastern Europe (German, French and Austrian banks) and secondarily in Latin America (Spanish banks). The scale of the global financial crisis warrants redoubling the efforts to shore the capital of the global banking system.

Tier 1 Shortfall
AUSTRIA 70 (49)
BELGIUM 95 (108)
DENMARK 37 (80)
FINLAND 27 (9)
FRANCE 492 (792)
GERMANY 291 (560)
GREECE 31 (14)
ICELAND 14 (5)
IRELAND 81 (98)
ITALY 287 (184)
NORWAY 30 (28)
PORTUGAL 25 (25)
SPAIN 250 (211)
SWEDEN 45 (86)
Total 2,438 (3,397)

Tier 1 Shortfall
East Asia
HONG KONG 53 (30)
JAPAN 563 (519)
KOREA REP. OF 75 (44)
TAIWAN 44 (37)

Total 1,189 (758)