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When Lehman Brothers Holdings collapsed, European officials reacted with barely concealed outrage at their American counterparts. By letting the investment bank go bust, they contended, the U.S. threatened to unleash a contagion that could crash the global economy. "For the equilibrium of the world financial system, this was a genuine error," Christine Lagarde, then the French Finance minister, said at the time.

Today, Europeans have no one to blame but themselves for their problems. Although the crisis had its origins in the U.S. banking system, the fallout has been far greater in Europe, where the region's undercapitalized banks buckled badly and are still far from healthy. Ireland's banking failures virtually bankrupted the state; Spain needed a  €100 billion ($133 billion) bailout to prop up its cajas, or savings banks, after an epic property collapse; two of the U.K.'s Big Four banks remain nationalized; and even the region's healthier banks are still held hostage by the euro area's debt crisis. Five years after Lehman it's the European banking system that poses arguably the greatest risk to global financial stability. (See also " Ireland's Banks Take the First Step on Long Road to Recovery")

 
Deutsche Bank's Jain (top) and Barclays'
Jenkins are raising capital. (Photographs by
Munshi Ahmed/Bloomberg, top, and Matthew
Lloyd/Bloomberg)


The threat reflects the sheer scale of the European system. Unlike the U.S., the region's economies rely much more on bank lending than on the capital markets to finance activity. Banking assets stand at a massive "35 trillion, or 3.3 times the European Union's gross domestic product, according to European Central Bank data. By contrast, U.S. banking assets amounted to $14.4 trillion, or 87.2 percent of GDP, at the end of March, according to the Federal Deposit Insurance Corp. Although European banks have taken some steps to shrink their balance sheets and raise capital, those actions fall well short of what's needed — and pale in comparison with the strides that U.S. banks have made toward rebuilding.

"Too much emphasis has been placed on the hope of the European economy recovering and not enough on banks' tackling their individual problems," says Sergio Ermotti, chief executive officer of UBS, which has taken some of the most drastic action to downsize, to meet Switzerland's rigorous regulatory standards.

Banks in Europe have reduced their balance sheets by a total of  €2.4 trillion since 2011. They have been slower to raise capital, although recent moves by Barclays and Deutsche Bank — which raised  £5.8 billion ($9.1 billion) and  €2.96 billion, respectively, with share issues — suggest that more banks may begin to move on this front.

"European banks are not even half way to becoming sustainable," Alberto Gallo, head of European macro credit research at Royal Bank of Scotland Group, wrote in a July 17 note to clients. Gallo reckons that the region's banks need to shed a further  €2.7 trillion in assets to meet the tighter capital and leverage ratios that regulators have imposed in the wake of the crisis. They will also need to raise a lot more capital: Gallo estimates the capital requirements of the 13 largest European banks at some  €60 billion.



The Legacy of Lehman: A Look at the World 5 Years After the Financial Crisis

The need for restructuring will be challenging for an industry that's struggling to regain its health. Pretax earnings at European banks rose by an average of just 3.7 percent in the second quarter from the same period a year earlier, compared with a 28.9 percent rise at U.S. lenders, according to StarMine, an equity analytics arm of Thomson Reuters. Many European bank stocks continue to trade at a discount to book value, whereas U.S. banks trade at a premium, on average, according to Thomson Reuters Datastream. "The discount to book value shows that investors don't put too much faith in banks' financial statements," says Nicolas Veron, visiting fellow at the Peter G. Peterson Institute for International Economics in Washington.

The restructuring, in turn, threatens to act as a brake on Europe's feeble economic recovery. Aggregate bank lending to nonfinancial companies in the euro area fell by 8.5 percent between its January 2009 peak and July of this year, to  €4.4 trillion, according to the ECB. The vicious circle between weak banks and weak economies has been a defining feature of Europe's debt crisis, making economic recovery — and banking reform — all the harder to achieve. "Since May 2012 banks in Europe have cut lending to nonfinancial companies by  €250 billion," RBS's Gallo tells Institutional Investor. "This will continue as banks try to recapitalize and meet stricter regulations." (See also " Europe Looks to Impose New Curbs on Universal Banks")

"Banks may need more capital, they may need to be safer, but they also need to operate in an economy that is competitive," UBS's Ermotti says. "The financial system can only be as strong as the economy it operates in. Capital and liquidity rules combined with the timing of implementation make it difficult for them to support the economy."

Ultimately, Europe needs a proper banking union to stabilize the industry and restore growth. By strengthening supervision, establishing a mechanism for resolving failed banks and creating a common EU financial backstop for the industry, such a union would break the link between indebted sovereigns and weak banks that is at the heart of the European crisis. But one year after EU leaders declared this as their top goal, opposition in Germany and other states is stalling progress.

EUROPE'S BANKS HAVE COME A LONG WAY from the dark days of 2008, but much of the sector's recovery to date reflects official intervention rather than efforts by the banks themselves.

After Lehman's collapse governments across Europe commited more than  €1.5 trillion in guarantees and capital injections to prop up the sector. The U.K. government was left holding 84 percent of RBS and 43.4 percent of Lloyds Banking Group, which had taken over a flailing HBOS. Germany's Hypo Real Estate Holding and Franco-Belgian lender Dexia collapsed, requiring costly interventions by all three governments. The Dutch government spent  €10 billion to bail out ING Group and oversaw a drastic reduction in the company's scope, including the sale of its insurance operations.

As the financial crisis transformed into the European sovereign debt crisis, the European Central Bank responded in late 2011 and early 2012 by injecting  €1 trillion of liquidity into the banking system through its long-term refinancing operations. And when speculation about a euro breakup hit a fever pitch in the summer of 2012, the ECB promised to buy the debt of troubled economies through its new outright monetary transactions program. These actions calmed markets, saved the euro and stemmed a flight of bank deposits from peripheral countries, but they haven't been a panacea.

"LTRO and other measures have helped the European banking sector, but the fact they are necessary is a function of limited confidence in the sector," says Kian Abouhossein, banking analyst at J.P. Morgan in London. "This limited confidence is down to the steps European banks did not take in 2008 — they didn't deal with their legacy assets, and they didn't raise capital in sufficient quantities."

Banks now need to make up for lost time. As it prepares to take over as Europe's chief banking supervisor next year under an overhaul of EU financial regulation, the ECB will require banks to undergo asset quality reviews. The central bank wants to make sure that lending institutions meet the EU's strict new standards for capital and leverage and aren't hiding dud assets on their books. It is determined to avoid the mistakes of two previous stress tests, conducted by the London-based European Banking Authority in 2011 and 2012, that were largely dismissed by market participants as too lenient.

"It's hard to say how much of a systemic risk is posed by the European banking sector, because there is still a lack of transparency, and that creates uncertainty," says the Peterson Institute's Veron. "There remains significant fragility in the system. We need a comprehensive public assessment of bank balance sheets."

National regulators have already begun stepping up pressure on banks to meet the new standards. Under an EU directive that implements the global banking capital standards known as Basel III, European banks must hold tier-1 capital of 7 percent of risk-weighted assets, up from 4 percent previously. In addition, banks will have to meet a new leverage ratio that requires them to hold equity capital equal to 3 percent of total assets. Banks have until 2018 to meet the target, but investors and regulators have been pushing them to do so earlier. For European banks that have used risk weightings aggressively in the past to reduce their capital needs, the introduction of a blunt tool like the leverage ratio will hit hard.

Other regulations may be looming. The so-called Vickers Commission in the U.K. has recommended that banks ring-fence their retail operations from their investment banking divisions to contain risks, while the EU's Liikanen report has called for them to separate their proprietary trading and other high-risk activities from mainstream banking operations.

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