Banks recapitalization – market value matters

The recent financial markets' volatility forced Greece, Belgium, France, Italy and Spain to extend bans on short-selling. The updated news regarding the measures taken by EU competent authorities to prohibit market abuse were published on the European Securities and Market Authority’s website on August 25, 2011. The other warning to shield financial institutions was reported by Christine Lagarde. The Managing Director of the IMF encouraged speeding European banks’ recapitalization at the Federal Reserve Bank of Kansas City’s annual conference in Jackson Hole on August 27, 2011. So, are the fears of the financial system’s collapse reliable and are protective actions reasonable?

One of the main ratios to capture the value of a public company is the price-earnings ratio (P/E), which is equal to the market capitalization divided by the net income. If a company generates steady cash flows and its share price falls it may seem that undervalued stocks are an attractive investment opportunity. However, danger may lie in its leverage. A company defaults once the market value of its liabilities exceeds its assets. Such being the case retained earnings may be used to increase capital, or the firm can issue new shares if it has access to the capital markets. Thus, the market value of debt-equity ratio is very important as it reflects a company’s solvency.

An inaccurate measure of a bank’s solvency may arise according to the leverage ratio which is introduced by the Basel Committee on Banking Supervision in the Basel III: A global regulatory framework for more resilient banks and banking systems. A measure of the minimum Tier 1 leverage ratio of 3% is based on banks' accounting balance sheets these do not reflect the performance of the market.

Market value matters for public companies. Banks recapitalization should not be ignored.