High leverage ratios could mean Europe's big banks are in deep trouble

Massive debts and lack of cash could sink some major European players, a new study warns

THE WOES of American banks may have dominated the headlines of late but massive leverage in the European banking sector means that many of the continent's largest banks are "a disaster in waiting", according to research by two European economists.

Dr Daniel Gros, director of the Centre for European Policy Studies and co-author of the study, says that the "overall leverage ratio" of Europe's 12 largest banks - that is, the measure of total assets to shareholder equity - is 35 to 1, compared with less than 20 for the largest American banks. Highly-leveraged bets were widely blamed for the demise of Lehman Brothers, which held almost $700 billion in assets despite having shareholder equity of just $23 billion (a ratio of 30 to 1). Gros says that it is "surprising" that Europe has been spared the traumas that have ravaged the US financial system given that the last year has shown how "any slight doubt about the solvency or liquidity situation of such highly leveraged institutions can lead to their demise in a matter of days".

While it's often said that certain institutions are "too big to fail", Gros suggests that many behemoths of the European banking sector are "too big to be saved". Deutsche Bank, for example, has an overall leverage ratio of 50 and has liabilities of €2 trillion - more than Fannie Mae's liabilities and more than 80 per cent of the entire German economy. Given that the German budget is bound by the rules of the Stability pact, this is "simply too much for the Bundesbank or even the German state to contemplate".

Barclays has a leverage ratio of 60 and its liabilities - more than £1.3 trillion - exceed the entire British economy. Belgian bank Fortis, even with a lower ratio of 33, has liabilities that are "several times larger" than Belgium's GDP, the researchers say.

Unlike the US investment banks, leveraged players such as Deutsche and Barclays do have a steady stream of cash through their depositors, enabling them to avoid the predicament faced by Lehman and others, who relied on uncertain sources of funding. Furthermore, both banks avoided the worst scars of the subprime mortgage debacle.

However, the AIG scare revealed the tenuous nature of their financial health.

AIG had insured more than $300 billion of corporate loans and residential mortgages for European banks. However, this insurance was for the purpose of "regulatory capital relief rather than risk mitigation", according to AIG filings.

In other words, banks entered into such guarantees so as to be able to hold less capital to cover their risks. The carnage in European financial markets in the days preceding the AIG bailout was related to fears that the insurer would have to default on its guarantees, thereby plunging European banks into chaos.

Most European banks report regulatory leverage ratios of close to 10, not Gros's figure of 35. This is partly explained by the aforementioned "regulatory capital relief" and partly by the fact that the investment banking units of European banks are not subject to regulatory capital requirements, he says.

While media attention has largely focused on American rather than European leverage ratios, such practices have not gone unnoticed in analyst circles. This month, Barclays was downgraded to "sell" by RBS on the basis that a "deeply-ingrained performance-led culture" had led to "a higher level of balance-sheet gearing than peers", not a good thing in "the current environment of financial system de-leveraging and heightened external scrutiny of banks' balance sheets".

Nouriel Roubini, too, has this week been warning that "the massive increase in leverage", the bursting of domestic housing bubbles and exposure to US toxic assets mean that "the financial crisis of the century will also envelop European financial institutions".

Roubini's pessimism is echoed by Gros. "European Central Bank and European regulators are living on borrowed time", he says.