LONDON Oct 14 Europe's banks are on the verge of being recapitalised under an attempt to halt a euro zone debt crisis and restore confidence in the battered sector.
European leaders appear sure to agree a plan, although details have not yet been finalised.
Here are the key issues:
WHY DO BANKS NEED CAPITAL?
Politicians want to make banks strong enough to absorb losses on Greek government bonds and other sovereign debt, and still have enough capital to withstand a possible recession without taxpayers being called on for emergency rescues.
HOW HIGH WILL THEY RAISE THE BAR?
Past attempts to shore up the industry have failed, so there are growing calls for Europe to hit banks hard, "bazooka-style" as did U.S. Treasury Secretary Hank Paulson in 2008.
Banks are likely to be told they need a minimum core Tier 1 capital ratio of 9 percent after being "stress tested" to estimate their losses from a two-year recession and on Greek, Irish, Italian, Portuguese and Spanish government bonds. The level has not yet been finalised, however, and could be 7 percent or 8 percent.
The new standard is likely to be based on a tighter definition of capital than used now, although not as strict as full force Basel III rules. Those rules will be phased in from 2013 until 2019.
HOW MUCH CAPITAL WILL BE NEEDED?
It depends on the minimum level that's set. Banks would have a shortfall of about 260 billion euros if the minimum level is 9 percent, based on previous stress test data and current bond prices. But that level would drop to 100 billion euros if the bar is set at 7 percent.
Banks have sold assets, shrunk loan books and retained earnings this year, which will reduce the amount needed. Including some of those measures, analysts at Citi estimated banks will need 64 billion euros to reach a minimum capital ratio of 7 percent and 216 billion euros if it is 9 percent.
WHAT'S THE TIME FRAME?
Banks are expected to be given about 6 months to raise the capital, EU officials said.
Proposals are expected to be agreed by EU ministers at a meeting on Oct. 23.
WHO WILL NEED CASH?
Royal Bank of Scotland , UniCredit , Deutsche Bank , BNP Paribas , Societe Generale , Commerzbank and Barclays would all each need over 10 billion euros based on end-December data provided by all banks and a minimum capital ratio of 9 percent.
They would need far less capital, or none at all, if a level of 7 percent was set. But even at that lower level Greece's six main banks -- including National Bank of Greece , Eurobank EFG and ATEbank -- could need more than 30 billion euros.
Some banks are better positioned than shown in the end-December data, however. Deutsche Bank and RBS, for example, have substantially reduced their loan books and sovereign holdings, reducing their needs.
WHERE WILL CASH COME FROM?
Private investors appear reluctant to pump cash into banks. Some national champions like Deutsche Bank or BNP Paribas may be able to raise money privately, potentially from Middle East or Asian sovereign wealth funds. But national governments are likely to have to provide the bulk of cash, with the new euro zone rescue fund EFSF available as a last resort.
CAN CAPITAL IMPROVE IN OTHER WAYS?
By reducing assets banks are improving their capital ratios. The recap plan is likely to increase pressure on banks to cut back on lending that uses a lot of capital, such as asset finance, unsecured consumer finance, trade finance, syndicated lending and some business lending.
Banks could also be told to cut pay for staff and dividends for investors to preserve cash.
WILL THE RECAPS HURT THE ECONOMY?
Very possibly. Banks are already cutting back on loans, and a rapid deleveraging could damage economic recovery efforts.
A potential way to limit the threat to the economy would be to give banks a tight deadline to raise capital.
"If given time, banks may attempt to shrink their balance sheets as a means to satisfying the new higher capital requirements. This could lead to a long-lasting credit crunch as banks restrict the availability of credit to the wider economy," said Michael Symonds, credit analyst for financials at Daiwa.
WHO IS RUNNING THE TEST?
The health check is being coordinated by the European Banking Authority (EBA), an EU body made up of banking supervisors from all the bloc's 27 member states. It sets the data banks must provide, but it's up to national regulators to make sure this happens. The EU's executive European Commission and the European Central Bank also play a role. The decision on capital ratios will be made by EU finance ministers.
HASN'T A "STRESS TEST" ALREADY BEEN DONE?
The EBA tested 90 lenders in July in a bid to shore up confidence. It gave investors a fuller picture of the euro zone sovereign debt held by each of the lenders, but only eight banks failed, needing just 2.5 billion euros.
The July test did not impose losses on government bonds held in banking books and was widely criticised as too soft.
WHAT TYPE OF CAPITAL WILL BE ISSUED?
Officials are still discussing the type of capital banks should top up with. Banks in France and elsewhere want to be able to use loss-absorbing hybrid instruments, like preference shares that can convert into equity if a bank hits trouble. A more traditional recapitalisation would provide good quality pure equity, but would be more dilutive and costly for shareholders.
"At one extreme we could see cheap, non equity Tier 1 capital injections that would prove positive, at the other, extremely dilutive equity issuance at well below book value," said Simon Samuels, analyst at Barclays Capital.
IS THERE A LEGAL RISK?
German banks say forced recapitalisations need a legal basis which doesn't exist yet. They don't regard it as emergency case (unlike 2008) that could justify a violation of property rights. "You can expect dozens of lawsuits, if you push ahead with these plans," a senior German banker said.
WHAT'S THE IMPACT ON NATIONAL FINANCES?
A capital shortfall of about 100 billion euros would equate to 0.7 percent of the expected GDP across EU countries, and a 260 billion euro hole would represent about 2 percent of GDP.
If Greece is forced to foot the recap bill for its bank it would likely push its debt-to-GDP ratio to more than 170 percent, from 157 percent. Although Spain and Italy could need to pump substantially more into their banks, financing a recap would only add 1 percent to their respective debt-to-GDP levels.
WILL A BANK RECAP BE ENOUGH?
Even a "bazooka" of a recapitalisation is likely to fail if it is not accompanied by support for bank funding and a plan to tackle sovereign problems. Bankers would like to see the ECB offer longer 2-3 year funding support for banks, fearful that a funding squeeze will become a major problem if it lasts into next year.
The leaders of Germany and France have promised the bank recap will be part of a package of measures set out by a Nov. 3-4 meeting of G20 countries.