“European banks remain at the heart of the euro area crisis. Despite actions to strengthen banks and build a banking union, confidence in the euro area banking system remains weak, and is likely to remain so until underlying concerns over low capitalisation of some banks are addressed. Low bank capitalisation persists in many countries despite an EU requirement that banks reach in 2012 a ratio of a minimum 9% of the best quality Core Tier-1 capital to risk-weighted assets, in excess of the current international requirements. Why has this new benchmark not been sufficient to boost confidence? In part, this is because it is based on risk-weighting of assets that likely understates risks, due to reliance on banks own internal risk models and, for example, the zero risk-weight given to sovereign debt. The ratio of Core Tier-1 capital to unweighted assets of euro area banks currently falls well short of 5% in many cases. This standard has been identified as a benchmark for well-capitalised banks in a recent OECD paper and it is more demanding than the minimum Basel III leverage ratio that will apply from 2018. Increasing the capacity of European banks to absorb losses, by increasing their capital relative to assets, needs to be addressed in the coming years. If the euro areas largest banks were to move to a 5% standard, the current capital shortage is estimated at around EUR 400bn (4¼ per cent of euro area GDP). This is not just a problem for banks in the periphery there could be large capital needs in the major euro area countries. Future capital needs could be lessened if banks were required to separate commercial banking and market activities, reducing the total assets of the banking business.”
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