Do European Banks Need Recapitalization?

On January 9th, Unicredit—Italy's largest banking unit—will see its share capital increased. The total maximum amount will be up to € 7500 billion. On Thursday, it was said that existing ordinary and saving shareholders would receive two new shares for each they own. The price is 1.943 euros per share and incorporates a 43% discount to TERP (Theoretical Ex Right Price) on January 3 of 3.4286 euros (whereas the official Unicredit market price in the same day was 6.40 euros). The market share of that Italian bank, however, has collapsed in the last two days, having lost 14.45% on January 4 and 17.27% on January 5, reaching € 4.48. Markets have apparently deemed the 43% discount too high (35% was widely anticipated, which was normally applied in the last banking recapitalization). Such a wide discount may be due to two situations that currently characterize the European banking market. On the one hand, there is disaffection for Italian securities from financial markets. Further, foreign investors hold 58.5% of Unicredit's capital. The major shareholders of the bank will participate in only a 24% capital increase, although the success of the operation is guaranteed by the possible participation of the banks advising on the deal. However, the signal is a general reluctance to underwrite the issue—particularly by foreign shareholders because, as mentioned, they may have lost their confidence to continue investing in the Italian market. The American investment fund Black Rock, a shareholder with 4.2% of bank capital, between 16 and 27 December (therefore immediately before the recapitalization) proceeded with the sale of most of its shares, so as to decrease its participation to the bank at 1.71%: a clear symptom of disaffection and lack of confidence in financing Unicredit. Nor we can regard it as a speculative sale, because the Unicredit market price in 2011 decreased by 60% of its value. However, another topic is even more important, as it will characterize the European banking market for a large part of 2012. The EBA (European Banking Authority) in October issued a formal recommendation (which we can assimilate more to an imposition than an advice) to the largest European banks to reach a level of 9% in the Core Tier 1 (the main indicator of financial strength) by June 2012. This means they have to recapitalize for € 114 billion if they want to restore confidence, to obtain the capital required to withstand possible shocks in the markets and make up for large write-downs on their sovereign debt holdings. As the Core Tier 1 is the ratio between equity capital and disclosed reserves (mainly powered by retained earnings) and total risk-weighted assets; the banks raise capital through requests to their shareholders and utilizing the retained earnings, or they have to reduce the amount of loans, accelerating the process of "deleveraging" already in place and fueling the fear of a “credit crunch” (worsening perspectives on the recession). The EBA has also indicated, for each country and for each bank, the amount of the shortfall to fill. Obviously, the widest are attributable to Italian (15.4 billion), Greek (30 billion) and Spanish (26.2 billion) banks. We will see in the coming months recapitalizations, such as Unicredit , which will be used almost exclusively to meet the limit of 9% of Core Tier 1. But the financial markets are so depressed that may not be able to support these operations and to provide the necessary liquidity. Unicredit will be the first test, and it does not seem to be going well.