Euro leaders warned over bank capital

Analysts see no end to eurozone crisis without rapid recapitalisation of troubled sector

European leaders risk inflaming a market panic if they capitulate to bank demands for more time to raise cash, they were warned yesterday as they met for a mini-summit ahead of a crunch weekend for the eurozone debt crisis.

French President Nicolas Sarkozy and Angela Merkel, the German Chancellor, arranged an impromptu meeting in Frankfurt last night – tagged on to an event intended to mark the retirement of Jean-Claude Trichet as president of the European Central Bank – with the heads of the European Council, International Monetary Fund, European Central Bank in an effort to make progress on arrangements for a Greek default. As well as agreeing the scale of the losses for Greek bondholders and the size of a beefed-up stability fund, they must also face up to the need for recapitalising the Continent's banks.

They face an acute dilemma. European banks are arguing there could be a new credit crunch if they are required to improve their capital positions over a short period of time, but a host of economic analysts warned yesterday that only a swift recapitalisation could ease the turmoil in the eurozone sovereign debt market, and that traders could violently reject anything that looks like a fudge. "Bank equity investors need an immediate capital injection," said Kian Abouhossein of JP Morgan, adding: "The discussed six-to-nine-month timeframe is unacceptable."

A poll of economists by Reuters found that 38 out of 39 believe banks should be required to raise more capital within a year. A majority argued it should be done within six months. Yet senior representatives of the International Institute of Finance, the global banking lobby group, have been pressing the case against a rapid recapitalisation in private meetings.

While international focus has been on the risks of a Greek default to French banks, German institutions too have significant exposure. A stress test of European banks in July, conducted by the regulator of the European Banking Authority, revealed the full exposure of German financial institutions to states on the troubled eurozone periphery. The sector holds €10bn of Greek sovereign debt, €2bn of Irish debt, €6bn of Portuguese debt, €21bn of Spanish debt and €36bn of Italian debt. All those sovereigns have seen their interest rates rise over the past year, reflecting investor doubts about their solvency.

It was reported last night that the next Europe-wide stress test will conclude only €80bn of new money is needed across the Continent's banks, a figure that is likely to be derided by analysts, whose models suggest up to three times that amount is necessary to protect the system.

Banks have two ways that they can increase their capital levels. They can shrink their assets, which consist largely of loans to the real economy, or they can raise more equity. Mr Ackermann says that if higher capital ratios are imposed immediately, banks will attempt to meet their commitments by shrinking their assets, which would have a devastating effect on economic growth.

But Mr Abouhossein said: "If it is a US-style Tarp programme, where the banks are required to take public money today, there will not be a credit crunch. If banks are given six to nine months to raise capital in the markets, then that would be a problem."