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In Europe, Juggling Image and Capital

Stung by souring loans and troubled government bond portfolios, many European banks are being forced by regulators to raise money to build up their cash cushions against future losses.

European Central Bank
Travelpix Ltd | Photographer's Choice | Getty Images
European Central Bank

That includes Santander , the Spanish banking giant that European regulators say has the biggest capital hole to fill: at least 15 billion euros.

So why, then, is Santander still planning to pay its shareholders 2011 dividends worth at least 2 billion euros in cash and even more in stock?

That question goes to the heart of the economic challenge that Europe faces in the year ahead.A combination of government austerity, and the imposition of bigger capital safety cushions that are leading banks to retrench, seem all but certain to plunge the Continent back into recession less than three years after emerging from the last one.

But many banks are taking actions that will only intensify the blow. To preserve their allure as global brands, while trying to compensate for their battered share prices, big European banks like Santander remain intent on maintaining rich dividend payouts to shareholders. At the same time, they are selling assets, curbing lending and taking other belt-tightening measures to satisfy regulators’ demands for more capital.

“Our dividend is a sign of our expected future profits,” said José Antonio Alvarez, the chief financial officer of Santander. “Unless our expectations change we try not to cut the dividend.”

Santander, though by many measures the most generous, is not the only bank paying dividends as it scrambles to raise capital.

Its rival, the Spanish lender BBVA, plans to pay out nearly half its profits to shareholders, despite being under regulators’ orders to raise 6.3 billion euros in capital. To a lesser but still significant extent, Deutsche Bank and BNP Paribas will also be paying out dividends as they try to take in money to build their capital cushions.

All this is a sharp contrast to the way capital-short banks in the United States slashed dividends to conserve cash during the depths of the financial crisis that followed the Lehman Brothers collapse in 2008. The American government also injected cash into the banks, as Britain did with its weaker institutions.

So far, European governments have shown no inclination to do likewise for their banks. And critics say the contrast with the American experience shows how much European regulators are out of step, or even out of touch, with the banks they supervise — with potentially disturbing ramifications for the European economy.

“I do not think Europeans understand the implications of a systemic banking crisis,” said Richard Koo, the chief economist at the Nomura Research Institute in Tokyo and an expert on the financial stagnation in Japan in the 1990s. “When all banks are forced to raise capital at the same time, the result is going to be even weaker banks and an even longer recession — if not depression.”

A paper Mr. Koo wrote on the subject has gone viral on the Web, with many picking up on his recommendation that the banking crisis will not be solved until European governments inject large amounts of money into their banks.

“Government intervention should be the first resort, not the last resort,” Mr. Koo said in an interview.

There is little doubt that European banks need shoring up right now. That fact was made clear Wednesday, when 523 banks tapped the European Central Bank for a record 489 billion euros(nearly $640 billion) in loans. Compared with their American peers, they have been much more dependent on borrowing in recent years to finance their lending binges.

On average, European banks’ loan books exceed their deposits by 1.2 times. In the United States the average loan-to-deposit ratio is 0.70. The upshot is that it will probably take much longer for Europe’s banks to unwind their bad loans and debt than it has for American banks.

The European Banking Authority, after a third round of stress tests in October, has ordered Europe’s fragile banks to raise more than 114 billion euros in fresh cash in the next six months. By June 2012, the region’s financial institutions will need to increase their so-called core Tier 1 capital ratio — the strictest measure of a bank’s ability to resist financial shocks — to 9 percent of assets.

That ratio, higher than the 5 percent preliminary target that the Federal Reserve set for American banks this week, reflects the acute capital strains that European banks are facing.

To meet the new European standard, analysts predict that the region’s banks could end up selling assets, shrinking loan books and shutting down foreign subsidiaries in a deleveraging process that may exceed 3 trillion euros in the coming years. And unless they are able to find better methods to restore their balance sheets — including direct support from their equally stressed national governments — many banks could well end up failing, analysts warn.

That would make it difficult for stagnating economies like Spain and Italy to recover, while potentially undermining growth in healthier places, like Eastern Europe and Latin America, where European banks are big lenders.

In many ways, Santander is better off than most of its European peers.

More diversified geographically than other banks in the euro zone, Santander so far this year has received nearly 70 percent of its profit from economies that do not use the euro currency, including Brazil, Argentina, Britain and, on a smaller scale, the United States, where it owns Sovereign Bank. In contrast to European banks like Dexia in Belgium and Commerzbank in Germany, Santander is not in need of a bailout.

Despite problems in the global financial system, analysts expect Santander to earn about 7 billion euros in profit this year, down from 8.1 billion euros in 2010.

What mainly worries European regulators is Santander’s exposure to the crumbling Spanish and Portuguese economies — which account for 34 percent of its loan book — and the 48 billion euros in Spanish government bonds on its books.

Santander, perhaps more than any other bank in Europe, has put a special emphasis on keeping its 3.3 million shareholders content through a regular diet of dividends and a 10 percent dividend yield that is unmatched among European banks. The family of Emilio Botín, the patriarch who serves as executive chairman of Grupo Santander, controls only about 2 percent of the company’s stock. So keeping the other shareholders happy is paramount.

This is especially true as speculation builds over whether Mr. Botín’s daughter, Ana Patricia Botín, who now runs the British unit of the bank, will become the fourth Botín to head the institution. Bowing to criticism that it is paying out too much cash, Santander said this week that it would increase the proportion of its dividends paid as new shares rather than cash.

In the past, that approach has prompted shareholders to take as much as 85 percent of their dividends in stock. But with the stock price down about 30 percent over the last year, investors have been taking fewer than three-quarters of their dividends in such a manner. If the stock continues to decline, and market uncertainty rises, Santander could have to provide more cash for dividends.

Mr. Alvarez, the chief financial officer, conceded that the dismal performance of the local economy was forcing the bank to cut back on its Spanish exposure, with loans inside the country expected to be down 4 to 5 percent this year.

On Monday, the Bank of Spain released data showing that bad loans on the books of the nation’s commercial banks, mostly in the real estate sector, had reached 7.4 percent of total lending — the highest level since 1994. Santander’s nonperforming loan ratio in Spain has increased to 5.1 percent, up from 3.4 percent in December 2009.

Even so, and despite its dividend payouts, Mr. Alvarez said that the bank would exceed the new European regulatory guidelines by achieving a 10 percent capital ratio next year — largely by converting 7 billion euros of bonds into equity, issuing new shares and selling assets.

To date, the European Banking Authority has not ordered European banks to curb dividends to meet capital targets, suggesting that banks should clamp down on bonuses instead. But with compensation levels at euro zone banks generally not as high as their American and British peers, the savings to be made there will not be substantial.

Instead, analysts expect further retrenchment by the banks, especially as economic conditions grow worse.

“We have not seen the really stressed selling yet,” said Tim Babich of Fortelus, a London hedge fund that invests in distressed assets throughout Europe.

Mr. Babich said that as banks find it more difficult to raise funds, they will move faster to cut down on loans and unload lagging assets. He expects that to be particularly true in Spain, where Santander and other banks sit on failed real estate loans worth hundreds of billions of euros but have been slow to recognize losses on most of them.

If everyone starts trying to sell assets and questionable loans at the same time, Mr. Babich warns, watch out. “It could lead to a depression,” he said.

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