Regulators should tell financial institutions to raise capital or risk being wiped off the map. The US Federal Reserve has temporarily averted a meltdown by swiftly sponsoring the rescue of Bear Stearns Companies Inc. and allowing other brokers to access its coffers. But the financial system is still fragile. The best way to shore it up is to require banks, brokers and other financial institutions to raise more capital.
Banks, of course, are reluctant to raise capital because it will dilute their existing shareholders. But the Fed and other authorities around the world need to leave them in no doubt that there is a limit to state generosity.
There could be plenty more trouble on the way. The credit crunch had landed banks with about $200 billion (Rs8.12 trillion) of writedowns and charges by the end of last year, according to Deutsche Bank AG. But writedowns to CDOs, which accounted for about $150 billion of that, look to be only a little more than halfway through. And trouble in neighbouring areas, such as higher-rated Alt-A mortgages and commercial property books, is only just beginning. And that’s before building in any cushion for a deep recession.
The damage wouldn’t be such a problem if it was spread evenly. US and European Union banks sailed into the crisis with total capital of about $1.9 trillion, according to UBS. That is enough to withstand $400 million of write-downs without dropping their average tier I capital ratio far below 7%, even if they made no profits and had to take back assets they pushed into off-balance-sheet funding vehicles, such as conduits.
But the hit has been taken by relatively few victims. Two-thirds of the subprime write-downs up to the end of last year were swallowed by 10 institutions: AIG, Bank of America, Citigroup, JPMorgan, Merrill Lynch and Morgan Stanley in the US and Europe’s UBS, IKB, WestLB and Royal Bank of Scotland (RBS), according to Deutsche. They retain more than 60% of the world’s exposure to subprime assets, and roughly half its stuck loans, too.
And some smaller peers have taken relatively large hits. Fortis’ €2.7 billion (Rs17,145 crore) write-down dragged its bank into a fourth quarter loss. While HBOS Plc. has avoided big losses so far, its big bet on Alt-A may get it into hot water. That is one reason it has been vulnerable to rumours.
Shoring up capital bases is likely to prove painful, as there are a few easy options. A small number of banks are sitting on big profits on quoted industrial stakes, which could be sold at short notice if times got tough. Italy’s UniCredit has 4.5% of Generali, worth €2.8 billion, while Spain’s BBVA’s 6% stake in Telefonica is worth more than €8.5 billion.
But most banks don’t have significant quoted stakes. And while they do often have unquoted assets, they aren’t simple to liquidate in a buyers’ market. Fortis’ €2.1 billion sale this week of half its asset management arm to China’s Ping An looks the exception rather than the rule. RBS—which along with Fortis foolishly extended itself with the top-of-the-market purchase of ABN Amro—has been trying to get shot of its Angel Trains leasing business for months.
Raising money by floating a business on the stock market also won’t be easy given market conditions. Last week’s Visa initial public offering, which gave timely cash injections to US banks including Bank of America, Citigroup and JPMorgan, is also something of a one-off. Other options for raising capital look unappealing. Tapping the credit markets for so-called hybrid capital is expensive. HBOS raised £750 million (Rs6,090 crore) in tier I capital last week at 9.5%, four times the spread over swaps it could have got away with a year ago.
Selling shares to rich foreign investors might seem an attractive option. And, in the early stages of the crisis, that’s exactly what the likes of Citigroup, Merrill Lynch and UBS did. They tapped sovereign wealth funds (SWFs) in Asia and West Asia for capital. The snag is that SWFs have lost about 40% on the $50 billion they have plunged into rescue plans to date— so they may be reluctant to throw good money after bad.
What this means is that to raise significant capital, financial institutions are likely to have to tap their own shareholders. Scrapping dividends, as UBS has done, would help a bit. But the main solution will be to launch deeply discounted rights issues—as Société Générale, the French bank has done with its €5.5 billion rights issue last week to fill the hole left by its mega fraud. Two Portuguese banks—BCP and BPI—have similarly got the message and announced rights issues to replenish weak capital coffers.
In recent weeks, officials have been ramping up the pressure. Hank Paulson, US treasury secretary, has been telling banks to review dividend policy and raise more capital. The US mortgage regulator has also done a deal with Freddie Mac and Fannie Mae that involves easing some of the constraints under which they operate in return for them raising “significant” capital—although it is not quite clear what significant means.
This pressure is probably not yet strong enough to achieve the desired effect. Many financial bosses are reluctant to ask shareholders for bailout money, perhaps fearing they could pay with their jobs. But the authorities need to remind banks that it is better to sacrifice the boss than the whole franchise.