????Banks fund their activities in many ways and through a myriad of currencies. The most reliable source of funding for a bank is common equity capital, followed by the money received from depositors through checking and savings accounts. But in Europe, especially in France, a large chunk of funding comes in the form of short-term loans from prime money funds, money market accounts and other banks. This short-term funding is rolled over nightly in some cases, making it an extremely unreliable and volatile source of funding. One reason Société Générale may be the first bank in Europe hit hard is because 73% of its total debt has maturities of less than one year, the highest ratio of any large bank in Europe.
????The Lehman collapse in 2008 showed the world how dangerous it was to depend on short-term funding. Rumors of the bank's imminent collapse caused dealers to pull their short-term funding and within days the bank was insolvent. A similar situation seems to be taking place in Europe, but in slow motion. For example, U.S. money market funds have cut their funding levels to French banks by 40% in the three months through August 11th, according to Deutsche Bank (DB). This has forced the French banks to take out U.S. dollar loans from the European Central Bank at a higher interest rate in order to have enough U.S. dollars to fund their capital markets and financing activities.
????Société Générale and Credit Agricole's U.S. dollar-denominated assets represent 19% and 14%, respectively, of their total balance sheet at the end of 2010, according to Barclays. Banks are required to hold a certain percentage of their assets in cash and other liquid securities to protect themselves from funding shortfalls that could be caused by not having enough dollars on hand.
????On Thursday the ECB, in coordination with the U.S. Federal Reserve and other central banks, said that it would extend maturities on its dollar loans from seven days to three months. This has helped to quell the violent downswing in French bank stocks, but it is only a temporary measure to give the banks enough time to sell assets and raise permanent capital. It should be noted that the Fed discount window was opened fully to broker dealers after Bear Sterns fell in the spring of 2008. It was widely believed that a liquidity crisis had been taken off the table for all U.S. banks, but it failed to address the root causes of the liquidity crisis that took Bear down to begin with: solvency and confidence. Of course, the Fed discount window was not enough to save Lehman Brothers and this temporary measure by the ECB won't save European banks either if they fail to build a strong capital buffer.
????Since 2008, banks have beefed up this buffer, known as Tier 1 capital, but the French banks have been slow to do so, making them more vulnerable to a short-term funding blip. Credit Agricole is the worst performer of the large banks in Europe in this regard, increasing its Tier 1 capital ratio from 8.1% in the first half of 2007 to just 8.9% in the first half of 2011. Société Générale has increased its Tier 1 ratio from 6.4% to 9.3% over the same period, but it remains at the bottom of the pack. In contrast, Suisse banking giant UBS has increased its Tier 1 ratio from 10.8% to a whopping 16.1% over the same period.
?? There is no magic number when it comes to the amount of Tier 1 capital a bank should hold. It just needs to be high enough in which investors feel confident that the bank can withstand future losses.
Urgent recapitalization
