Why Europe's Bank Don't Have Enough Capital

(Bloomberg View) -- Europe’s economic malaise has a lot to do with its crippled banking system. Making that system more fragile seems like the wrong way to address the issue.

With the European Central Bank taking interest rates deeper into negative territory and the euro-area economy languishing, investors have become more concerned about the future profitability -- and perhaps the viability -- of the region’s banks. As a result, regulators are coming under pressure to ease capital requirements, on the grounds that this will help banks start making money and lending again.

Such logic perpetuates a misunderstanding of what bank capital is -- a point that Hyun Song Shin, head of research at the Bank for International Settlements, made eloquently in a speech last week. In its purest form, capital is equity financing, money from shareholders that banks can lend. Unlike debt, it has the advantage of automatically absorbing losses in bad times. When banks have more of it, they can borrow on better terms, and are more capable of taking the kinds of risks that make the economy dynamic. As Shin and a colleague demonstrate in a new paper, higher capital levels are strongly associated with higher lending volumes, and could make the ECB’s stimulus efforts more effective.

So it’s puzzling that euro-area regulators haven’t done more to increase capital levels. As of mid-2015, the aggregate equity at the nine largest euro-area banks amounted to less than 4 percent of assets, about two percentage points short of the already-low levels at the largest U.S. and U.K. banks. Instead of requiring banks to retain equity, regulators have allowed them to pay out billions of euros to shareholders in the form of dividends. Here’s a chart (inspired by one in Shin’s speech) showing the cumulative payouts at banks in the Euro Stoxx Banks Index since the global financial crisis started in 2007:

Why Europe's Bank Don't Have Enough Capital

Banks have paid out more than 100 billion euros to investors in this period. Had they returned less money, they would have more scope for lending and taking risks. Relaxing capital requirements to help them survive in a weak economy is backward thinking. Regulators should instead require them to operate with more equity capital, so they can help the economy grow.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story: Mark Whitehouse at mwhitehouse1@bloomberg.net.