Europe's banks have too little capital, and the shortfall is greatest in France and Germany, rather than in those members of the euro zone that are most directly affected by the currency area's crisis, the Organization for Economic Cooperation and Development said. Investor concerns about a potential breakup of the euro zone have eased in recent months, with yields on Spanish and Italian government bonds falling significantly. That in turn has boosted confidence in the currency area's banks, which are big holders of government bonds. But in a report, the OECD said the euro zone's banks still need to boost their capital by around EUR400 billion, the equivalent of 4% of the currency area's annual economic output. "There has been a recovery of sentiment around Europe and that is obviously very welcome," said Sebastian Barnes, counsellor to the OECD's chief economist. "But the solidity of that recovery would be strengthened by the kind of measures we are talking about." The Paris-based think tank said higher capital levels are essential if investors are once again to have confidence in the euro zone's banks, become willing to fund them, thereby enabling them to increase their lending to households and businesses and bolster weak economic growth. Mr. Barry stressed problems in the banking sector are hindering needed changes in the structure of many euro-zone economies, which need to switch from output that was targeted at domestic demand to exports. "We're seeing a serious contraction in credit," Mr. Barnes said. "It's still nowhere near normal levels, and that makes it very difficult for those countries that are undergoing massive adjustments, and need to reallocate resources." Lending to the euro zone's private sector fell 0.8% in the year to November, according to ECB data, but it has fallen by 5%-8% in the countries most affected by the crisis, such as Greece and Spain. In an effort to repair the currency area's banks, EU leaders last year set them the goal of having best quality "Core Tier-1" capital equivalent to a minimum 9% of risk-weighted assets. But the OECD said meeting that target has failed to boost confidence because it relies on banks' own assessments of the risks associated with their assets, and is based on the assumption that no risk at all attaches to holdings of euro-zone government bonds. Instead, the OECD believes banks should hold capital equivalent to 5% of all assets, in line with US practice. That "leverage ratio" is more conservative than new international regulations due to come into force by 2019, which allow banks to operate with a ratio as low as 3%. On that basis, it continues to see a large shortfall. Surprisingly, the capital deficit is largest in France, Belgium and Germany, which are part of the euro zone's supposedly strong northern "core" rather than its troubled south. Indeed, the OECD estimated that French banks face an aggregate capital shortfall equivalent to 7.5% of the nation's annual economic output, while German banks face an aggregate shortfall equivalent to 5.5% of gross domestic product. "This is not just about a bailout program for the periphery," Mr. Barnes said, referring to support provided by the euro zone to Spain. "It's a problem that needs to be addressed in all countries. The core countries have some really big issues to deal with." Making good a shortfall of such magnitude appears daunting in a part of the world that is notoriously short of government funds. But Mr. Barnes said the capital gaps don't need to be closed immediately, and that what is most important is to convince investors that the currency area is on the right path. If policy makers succeed in doing that, private investors may be prepared to get on board and provide some of the needed capital. Mr. Barnes cited the Irish government's sale earlier this week of part of its investment in the Bank of Ireland as a source of encouragement. "It's a sign that people are looking for the kinds of yield you can get from these kinds of investment," he said. "When the cycle turns, bank profits will recover." However, he conceded that it is "likely that additional public money will be needed," including funding from the European Stability Mechanism, the euro zone's bailout fund. Mr. Barnes also said that were the commercial banking and investment banking activities to be separated, the capital needs of euro-zone banks would be reduced. Write to Paul Hannon at paul.hannon@dowjones.com

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