It’s time for European banks to shrink

FORTUNE — Banks in the U.S. have had a tough earnings season, but their counterparts across the pond in Europe seem to be having an even harder one. From Deutsche Bank to UBS to Rabobank, it seems that old demons and lackluster performance have hit the purse of nearly every integrated European bank.

But European banks have an even more worrisome problem in the form of nonperforming loans, which have more than doubled to an estimated 1.2 trillion euros in the last five years. And banks had hoped to pay off their commitments and square their legal woes with future earnings, but that hasn’t gone very well. It may be time for them to finally face facts and start truly selling assets to cover their bills and clean up their balance sheets once and for all.

Deutsche Bank (DB), Europe’s largest bank, shocked the market earlier this week when it reported results that were well below analyst estimates. A surprise 1.2 billion euro provision for litigation charges in the quarter ending in September pushed the firm’s net income down some 94% from the same time last year to 41 million euros. That was less than a tenth of the 430 million euros expected.

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And Deutsche Bank is far from alone here. It seems like every major international bank is facing similar issues — to varying degrees of severity. Rabobank, the Dutch bank, recently said it paid some $1.1 billion for its role in manipulating Libor. Regulators aren’t taking any chances here and are pushing banks to put aside the necessary cash to cover their future legal claims. Swiss regulators actually ordered UBS (UBS) to add to its litigation reserves last quarter even though it had already settled its Libor legal woes, promising to pay some $1.5 billion for its role in the worldwide scheme.

In the last few quarters the banks had actually started to decrease their legal reserves for the first time in years as many had believed that the worst was behind them. After all, it had been well over five years since the lead-up to the financial crisis. If there were any future legal issues, they gathered they could simply pay for them using current earnings.

Unfortunately it hasn’t worked out that way. Not only have the legal issues continued to gnaw at earnings, the banks have had a hard time making money. For example, Deutsche took a 10% hit to its overall revenue in the last quarter thanks to poor operating performance in several key divisions. The firm’s massive fixed income trading desk reported revenues that were down some 50% from the previous year.

As the banks struggle to keep their head above water they will also be expected to meet new and stringent capital reserve requirements. The European Central Bank announced last week it would be conducting new stress tests on 128 banks to see if they have the necessary capital on hand to deal with another financial crisis. With diminished cash on hand due to the poor operations and even more stashed away in litigation reserves, the banks will need to somehow pump up their equity to meet the European capital requirements, which call for banks to have at least 8% of their capital on hand at all times.

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Banks in the eurozone have clearly been backed into a corner. The stress tests performed by the ECB are expected to be more stringent than the ones in the past, so many banks will need to shore up their capital base. This is made even more pressing given that the banks have some 1.2 trillion euros of nonperforming loans on their books, according to a report by PwC. That means that they will probably need to be written down, requiring the banks to raise even more capital.

Banks have several ways to address this solvency issue. They could hoard capital by cutting back on lending, but regulators probably won’t let them do that. They could sell more stock, but issuing equity in this manner dilutes current shareholders, making them very angry. Banks that are in real trouble could ask for assistance from their respective governments, but this really hurts the bank’s reputation and adds a whole host of new problems.

Probably the best way to get out of this mess would be for the banks to simply offload assets. This would lower the amount of capital they would need to have on hand, since it shrinks the denominator in the capital buffer equation. Banks in Europe have around 46 trillion euros in assets, so there is plenty of stuff they can sell. But they have been reticent to shrink. So far this year, European banks have sold just 46 billion euros in assets, equating to a tiny 1% of total assets.

As such, the European banks will need to step up their asset sales in the next few months if they hope to meet their capital requirements and fill the holes left by failed loans. PwC estimates that the banks could offload some 2.4 trillion euros next year. While that is a significant bump up from sales this year, it still might not be enough to meet the new capital requirements.

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But too many assets hitting the market at the same time could be counterproductive as it would send asset prices tumbling. The ECB could prevent a massive fire sale by creating a resolution trust corporation that the banks could transfer assets to for sale at a later date. This would get the assets off the banks’ balance sheets without having to take a nasty write-down, which would make the situation even worse.

It seems like the earliest movers will be able to gain the best prices for their assets. American and Asian investors have poured billions into the continent this year betting on an economic recovery in the region, so they will probably be hungry for any kind of European investment vehicle. If the recent dismal earnings reports are any measure, then there will probably be plenty of assets for investors to pick through.

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