spotfxtrader

This is from Graham Summers of Phoenix Capital Research via zerohedge here

As noted in yesterday’s piece concerning how and why Europe could bring about systemic risk, EU banks are likely leveraged at much, much more than 26 to 1.

Indeed, considering how leveraged and toxic US banks’ (especially the investment banks’) balance sheets became from the US housing bubble, the chart I showed you should give everyone pause when they consider the TRUE state of EU bank balance sheets.

This fact in of itself makes the possibility of a systemic collapse of the EU banking system relatively high. Let me give you an example to illustrate this point.

Let’s assume Bank XYZ in Europe has a loan portfolio of €300 million Euros and equity of €30 million Euros. This means the bank is “officially” leveraged at 10 to 1 (this would be a great leverage ratio for a European bank as most of them are leveraged to at least 26 to 1 or worse).

So… let’s say that 10% of the bank’s loans (read: assets) are in fact worth 50% of the value that the bank claims they’re worth (not unlikely if you’re talking about a PIIGS bank). This means that the bank’s actual loan portfolio is worth €285 million (10% of 300 is 30 and 50% of 30 is 15).

With equity of only €30 million, the bank, at some point, will have to take writedowns or one time charges on its loan portfolio that would erase HALF of its equity. At this point, the bank becomes leveraged at 19 to 1 (€285 million in assets on €15 million in equity).

This announcement would result in:

Depositors pulling their funds from the bank (thereby rendering it even more insolvent)
The bank’s shares plunging on the market (raising its leverage levels even higher as equity falls further).

Thus, at a leverage ratio of 10 to 1, even a 50% hit on 10% of a bank’s loan portfolio can result in the bank needing a bailout or even collapsing.

Now, what if that €300 million in loans is actually the amount the bank’s in-house risk models believe to be “at risk” and the REAL loan portfolio is around €800 million?

Immediately, we realize that the bank is in fact leveraged at 26 to 1. At this level even a 4% drop in asset prices erases ALL equity rendering the bank insolvent.

And yet, based on Basel II requirements, this bank can claim in all public disclosures that it is only leveraged at 10 to 1. With this in mind, you should understand why the banks lobbied so hard against a rapid implementation of Basel III capital requirements (which would require equity and capital equal to 10.5% of all of risk-weighted assets.)

Indeed, Basel III requirements which were meant to go in effect at the end of 2012 will now gradually begin to be implemented in 2013. And banks will have until 2015 to adjust to the new capital requirements and until 2019 conservation buffers in place.

With that in mind, take my XYZ bank example, apply it to all of Europe, assume leverage ratios of 26 to 1 at the very minimum (Lehman blew up when it was leveraged at 30 to 1), and take another look at the housing bubbles in the above chart.

In simple terms Europe’s entire €46 trillion banking system is in far worse shape than even the US investment banks were going into 2008. And this is based on their leverage ratios alone.