Banks Are the 'Grenade,' Not the Canary in a Coalmine

Banks are the key to fixing Europe's ongoing economic crisis, and they must be helped to lend while recapitalization of European financial institutions takes place early next year, analysts said on Tuesday.

LdF | Vetta | Getty Images

The European Banking Authority (EBA) released recommendations earlier in December urging European banks to raise capital to cover a shortfall of 114.7 billion euros ($150 billion) it identified following stress tests.

National supervisory authorities in European Union states have until January 20 to receive plans from banks detailing the actions they intend to take to reach the set targets.

These measures were necessary in order to make sure that banks will have enough cash after taking into account the falls in the prices of European sovereign bonds such as Italian bonds, Spanish bonds, Portuguese, Greek or Irish bonds.

Some analysts have called banks the canary in the coalmine, saying that they can predict whether the economy will recover or whether it will get worse. But Ralph Silva, research director at SRN, said banks are more than that.

"I don't think they're the canary right now, I think they're actually the grenade because they are the ones that are going to fix this or make it worse," he told CNBC in an interview.

"This is not great news for the economy but we are dependent on these banks more so now than we ever have been, they can turn us around or can take us down," Silva added.

Estimates regarding capital needs for European banks ranged from as much as 275 billion euros to as little as 80 billion euros.

'Exceptional and Temporary' Buffer

The EBA recommended that European states require banks to strengthen their capital by building up "an exceptional and temporary capital buffer against sovereign debt exposures to reflect market prices as at the end of September."

In addition, banks will be required to establish "an exceptional and temporary buffer" so that their Core Tier 1 capital ratio reaches a level of 9 percent by the end of June next year, according to the EBA recommendations.

The Core Tier 1 capital used by the EBA strips out hybrid instruments including existing preference shares but includes existing government support measures and has been the target of criticism from some US analysts, who have said certain government support measures should not be considered part of Core Tier 1 capital.

Last week, The European Central Bank offered 489.2 billion euros ($643.8 billion) in an auction of three-year loans, much higher than estimated, with a total of 523 bidders.

Analysts at Danske Bank said that on the positive side the auction had "clearly filled a gap for banks and the massive take-up in this first auction implies that euro liquidity is not likely to be a major concern in the coming years."

But, on the negative side, "the problem is that nothing is solved in terms of the capitalization of European banks and this is in fact the binding constraint for many banks," they added.

"In addition the large take-up can be seen as a sign of weakness and proof that European banks are still in intensive care instead of the recovery ward," Danske Bank analysts said.

The race to recapitalize Europe's banks must not lead to the drying up of credit for businesses and individuals, analysts warned.

"We need to force them to do the right things but right now we're forcing them to do the wrong things for the economy and the right things for themselves," Silva said

"We have to sacrifice some of these banks, we have to make sure that they lend to the right people at the right time and that's why I think the solution is a political one not an ECB one," he added.

According to the EBA, banks must recapitalize by issuing common equity and contingent capital, retaining earnings, cutting on dividends or selling some non-core assets – measures that would ensure they do not cut lending.

Banks in Greece, Spain, Italy, Germany, France and Belgium have the biggest shortfalls in capital, according to the EBA.