Why European Banks are Undercapitalized and What Should Be Done About it

9 Pages Posted: 21 Feb 2018

See all articles by John D. Finnerty

John D. Finnerty

Finnerty Economic Consulting LLC; Fordham University - Finance Area

Laura Gonzalez

California State University, Long Beach - Department of Finance, Real Estate & Law; Fordham University

Multiple version iconThere are 2 versions of this paper

Date Written: Fall 2017

Abstract

Major European banks are significantly undercapitalized as compared to large American banks, and, more importantly, as compared to the capital levels they would need to survive another severe financial crisis. Bank capital shortfalls in Italy, Spain, Germany, France and the United Kingdom, in particular, are largely the consequence of European bank regulations that: (1) apply static risk weights to assets like mortgages and sovereign debt; (2) fail to require an overall market‐based capital ratio that is high enough to enable banks to survive a severe financial crisis; (3) fail to get banks to promptly write down their impaired assets to market value; (4) subject banks to weak stress tests that can create a false impression of capital adequacy; and (5) fail to compel banks to retain sufficient earnings and to raise sufficient capital externally to eliminate capital shortfalls promptly, all apparently out of fear that being tougher might cause investors and customers to lose confidence in the banks. This article summarizes important recent independent bank stress testing that has quantified the capital shortfalls in European banks. The recent highly publicized regulatory interventions to resolve failing European banks were inevitable due to these shortfalls. The authors recommend steps European bank regulators should take to address the problem and to eliminate the risk of serious capital shortfalls. In the absence of such steps, bank depositors, customers, and security holders should be prepared to expect further unwelcome surprises as the risks inherent in allowing undercapitalized banks to operate will continue to materialize in more bank failures.

Suggested Citation

Finnerty, John D. and Gonzalez, Laura, Why European Banks are Undercapitalized and What Should Be Done About it (Fall 2017). Journal of Applied Corporate Finance, Vol. 29, Issue 4, pp. 65-71, 2017. Available at SSRN: https://ssrn.com/abstract=3127152 or http://dx.doi.org/10.1111/jacf.12262

John D. Finnerty (Contact Author)

Finnerty Economic Consulting LLC ( email )

60 East 42nd Street
Suite 2910
New York, NY 10165
United States
2125991640 (Phone)
2125991242 (Fax)

HOME PAGE: http://www.finnecon.com

Fordham University - Finance Area ( email )

113 West 60th Street
New York, NY 10023
United States
2125991640 (Phone)
2125991242 (Fax)

HOME PAGE: http://www.finnecon.com

Laura Gonzalez

California State University, Long Beach - Department of Finance, Real Estate & Law ( email )

United States

Fordham University ( email )

2008-2016
New York University Visiting Scholar 2014
New York, NY NY 10023
United States

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