Thursday, October 27, 2011

Georges Ugeux's views on EU bank recapitalisation

Georges Ugeux is a contributor to the Huffington Post but also actively writes in a finance blog which is influencial in the french speaking world. In a discussion pertaining to the resolution of the EU banking/sovereign debt crisis,  which he has some involvement with (1), he says that recapitalising banks would dilute shareholder value. We will look into this and conflicted positions he has taken on this topic.

His comment that raising capital would dilute existing shareholder value (2) is relevant to ongoing events because at the time it was made there was talk of mandating banks to take such action. This was since confirmed in a release by EU authorities, which he disapproves in his last post. We simply don't understand his reasoning. His consideration for past prices rules out that it can be valid. We submit to him, instead, this identity:
value of equity = value of the firm - value of creditor's claims
Based on this, we refute that there is dilution (see below), because first term on the right hand side are not influenced by the structure of capital. At least, to a first approximation. In practice, the leverage of banks is very high (20+), which induces an excessive bankruptcy risk that weighs on the value of the firm. Therefore, an action to reduce this leverage should raise the value of the firm. This is standard Modigliani and Miller logic.

As for his conflicted positions, it suffices to look at the titles of his posts. Late September, he warns of systemic risk in Europe.  See here. Mid October he says there is no systemic banking crisis, except if... See here. In early Septembre, he said that recapitalizing the banks was mandatory. See here. But in his mid-October post, he backtracks : he argues against a speedy recapitalisation, leaving the banks 8 years to achieve the Bâles III targets. It’s only about replacing one source of financing (debt), with another (equity) for a couple of % points of the total size of their balance sheet: is he telling us banks don't know how to do that?!  While much of his rhetoric is about sparing the taxpayer (See here), his mid-October post argues that, if needed, the government should provide funding to the banks, but not through shareholder ownership. Isn't that repeating the mistakes of TARP and its European analogues, though : lend to the banks, no strings attached? 

As a comparison, in an editorial, in August, the Financial Times advocated a speedy, private investor only, recapitalization of banks (notably through a debt-equity-swap), in order to "put unsecured bondholders where they belong – behind both taxpayers and depositors". See here. Some of that flavor can be found in the new EU plan which states that
The banks' distribution of dividends and bonus payments should be constrained until the target of 9% is achieved.

The banks should first raise capital from private sources, including through restructuring and conversion of debt to equity instruments.
Refutation of stock dilution

A bank balance sheet in the eurozone looks like this:
At market prices, assets are worth 100
95 are funded through borrowing
5, therefore, is the (market) value of equity.
EU government mandates banks to raise equity to 9, but let's round it to 10. There are many ways to achieve this, but let's assume 5 of the 95 come due tomorrow. The bank then raises 5 of capital (in exchange for shares) to pay for it. Here is the new bank balance sheet:
At market prices, assets are worth 100
90 are funded through borrowing
10, therefore, is the (market) value of equity. 
The old shareholders are entitled to 50% of the new value of equity, that is 5, which is unchanged.

(1) Georges Ugeux's affiliations include the Institute of International Finance, which Wikipedia describes as the world's only global association of financial institutions and is the primary negotiator with EU governments. (2) La dilution vient du fait que les actions des banques seront emises a des prix tres inferieurs aux prix d’acquisitions precedents. Par exemple, dans le cas de BNP Paribas, la Belgique a souscrit a des actions a 68 euros en 2009 et verrait de nouveaux actionnaires entrer proched de 20 euros. Cela dilue leur pourcentage a des prix inferieurs aux siens. Rédigé par : Georges Ugeux | le 23 octobre 2011 à 13:01

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