European banking – A perfect storm?
The future of the Euro area banking system hangs in balance. It would not be an exaggeration to say that, were it not for more than a trillion Euros of implicit and explicit public support in the form of capital injections and funding guarantees from Member States and liquidity support from the European Central Bank, the Euro area banking system could well collapse.
While some may think that, four years after Lehman’s collapse, the biggest problems of European banks are now over, that may not be true. All things considered, the biggest challenges for Euro area banks still lie ahead. In particular, the combination of largely unreformed banking models, large scale regulatory changes and uncertainties around their final shape as well as the worsening Eurocrisis mean that Euro area banks face very large, potentially insurmountable challenges.
The EU economy depends on banks and the banks depend on wholesale funding
In the Euro area, unlike in the United States, the vast majority of credit is intermediated by the banking system. So banks are much more important for the health of the real economy in the EU than they are in the United States. Another distinctive, but related issue is that Euro area banks have large gaps between the deposits they manage to mobilise and the credit they provide. This gap has been traditionally plugged by borrowing in the wholesale markets, mostly in the form of what is called 'senior unsecured bonds'. These bonds are not secured against any particular assets on the bank’s balance sheet.
Investors who bought trillions of Euros of such bonds included pension funds, large insurance firms as well as US money market funds. However, the uncertainties and risks posed by the evolution of the Eurocrisis, and the fact that most Euro area banks have not quite recovered from the near collapse of the global financial system in 2008, have meant that these investors are still on strike. In the immediate aftermath of the crisis, EU banks issued almost €1 trillion of senior unsecured bonds that were guaranteed by Euro area member states. The problem now is that guarantees from troubled Euro member states such as Greece, Spain, Ireland, Italy and Portugal are pratically worthless and it is banks in these countries that need the most help. A proposal for a pan-European funding guarantees for banks which was heavily supported by us at Re-Define was defeated by parochial politics in late 2011.
ECB intervention was necessitated by the failure to agree to a pan-EU approach
The European Central Bank’s two 3-year Long Term Funding Operations (LTROs) were partly a response to this failure and the realisation that Euro area banks were not to be given funding support, some of them could well collapse as they ran out of liquid funds. The second related motivation for the LTRO was that the unavailability of funding would trigger a large scale deleveraging in the Euro area. Such a deleveraging involving forced fire sales of assets and a refusal to roll over loans and lines of credit would have had disastrous macroeconomic consequences for Europe. The LTRO allowed banks to borrow unlimited amounts of money at a paltry 1% rate of interest for three years against a wide variety of collateral. This has addressed the funding needs of many Euro area banks for the short to medium term, but at the same time potentially built up even more serious problems for the longer term.
But ECB support makes Euro banks a less attractive investment for bondholders
Pre-crisis, the senior unsecured bond holders of Euro area banks lent to banks in the confidence that were things to go wrong they would be high up in the creditor queue to collect at least part of what they had lent from the proceeds of the sale of banks assets that had not been pledged against particular borrowings. The stock of these so called ‘unencumbered’ assets was large. Post LTRO, most Euro area banks now have a much smaller stock of ‘unencumbered’ assets. What’s worse, the quality of this residual portfolio is worse than the average quality of the banks’ asset portfolio given that the good quality assets have been pledged to the ECB against LTRO borrowing. Asset encumbrance makes lending to Euro area banks which have borrowed LTRO funds more risky.
Euro area banks face massive funding challenges and it’s not obvious where and how they will get the funds to replace legacy borrowing and the ECB LTRO funds when they fall due. Replacing ECB funds in particular, which are available at just 1%, a rate banks will not get from anywhere else, would be hard. In particular a serious exit problem could arise when the hundreds of billions of LTRO funds all mature at the same time and banks rush en masse to borrow to replace those funds.
Recession in the EU will weaken banks and reduce their attractiveness
With the Eurocrisis dominating headlines, it’s not hard to see why confidence in the Euro area banking system is low. While the immediate funding problems, as discussed above, have been addressed reducing the likelihood of bank failures in the short to medium term, the real economy is poised at the edge of a cliff with the Eurozone as a whole expected to enter into a recession in 2012 and on the basis of our in-house estimate this will continue in 2013 unless the Eurozone seriously changes course. What is particularly problematic but natural is that the banks which face the most serious challenges are the ones located in program countries and others such as Spain and Italy which are likely to face the deepest recessions.
While austerity has made the headlines since the Eurocrisis first broke out, the reality of public spending cuts and tax increases has been more benign. The most brutal adjustments have been limited to the smaller peripheral countries such as Greece and Ireland. These cuts while very painful for the citizens of those countries have been macro economically insignificant for the Eurozone as a whole given the small size of these economies. 2012, by contrast, will see the biggest aggregate austerity measures being adopted throughout the Eurozone, including in some of the largest economies such as Spain and Italy and this will have very serious and negative repercussions for the Eurozone as a whole.
Particularly in Spain, but also to a lesser extent in other countries such as Italy, the collapse of growth will lead to a sharp increase in the amount of impaired assets and have a large negative impact on profitability as sources of earnings shrink and losses multiply. As the real economy deteriorates, the losses at EU banks will multiply and exert further pressure on already stretched sovereign finances.
The strengthening links between banks & sovereigns reinforce problems
The dance of death between sovereigns and banks in the EU will become ever more frantic. Spanish and Italian banks, in particular, have bought tens of billions of additional sovereign bonds using LTRO funds disbursed by the ECB. The collapse of growth and accompanying sovereign downgrades such as yesterday’s downgrade of Spain by S&P will put pressure on the perceived quality of these bonds and even if the European Banking Authority no longer asks banks to hold capital buffers against the market deterioration of sovereign bonds, banks holding large amounts of bonds of troubled sovereigns would come under immense market pressure. The perceived weakness of banks & the potential need for additional public support will in turn weaken the sovereign even more. The weakness of the Spanish banking sector and the potential burden this poses on the state was one of the stated reasons for the downgrade of Spain by S&P, for example. The downgrade of the sovereign is in turn likely to lead to further downgrades of Spanish banks as the quality of implicit sovereign support that rating agencies factor into bank ratings will fall.
Regulatory changes are reducing the profitability of EU banks
Pre-crisis, EU banks were able to get away with some of the lowest levels of capital in the world. The largest EU banks had leverage ratios well in excess of 60. They also enjoyed access to cheap wholesale funding from both domestic and international sources. In the run up to the crisis, they took to borrowing at ever shrinking maturities which was cheaper. The combination of very low capital basis and an excessive dependence on cheap short-term funding made EU banks both profitable and potentially very dangerous.
The biggest drivers of profits in an otherwise overbanked European market were excessive leverage and maturity mis-matches. Regulatory reforms underway now, so much as a four-fold increase in effective Tier I capital requirements as well as increasing regulatory intolerance for funding mismatches means that EU banks will no longer enjoy the profitability they did in the run up to the crisis. Given the problems that even otherwise healthy banks such as Unicredit have had mobilising additional equity and the fact that the ECB has fast become the primary source of wholesale lending in town which will pull the plug at some point, many EU banking models may simply fail the test of the market.
While regulatory reforms make banks safer yet less profitable (which may in fact be relatively attractive to bondholders in the longer term), the fact remains that as long as the Eurocrisis remains with us, no bank in the EU is safe, no matter what levels of capital it has. In the medium term then, regulatory tightening and the reduction in profitability it implies will only complicate the efforts of EU banks to mobilise unsecured funding and equity. Due to the future application of new regulations across the banking system, it also creates a transition problem as EU banks attempt to mobilise additional capital and funding at the same time and are much more likely to run into supply constraints.
Another complicating factor is that the biggest regulatory changes are happening even as the EU banking system remains very fragile and that the final shape and form of these changes remains very uncertain. Bondholders and shareholders are reluctant to invest with the assumption of a regulatory regime A when they might end up with a regime B that looks significantly different.
The imminent announcement of bank restructuring plans adds another risk factor
The fact is that banks in the EU have benefited from and continue to enjoy a massive public subsidy. As we highlighted at the beginning of this note, without the current and recent public support that has been provided by EU sovereigns and the ECB, the Euro area banking system would almost certainly have crumbled since the collapse of Lehman.
Undoubtedly, without public support, the shareholders and bondholders of EU banks would have lost hundreds of billions in the crisis. So, the existence of both the implicit and explicit public support has provided massive benefits to the shareholders and bondholders of EU banks. The EU authorities rightly want this public subsidy removed in the near future. The on-going discussion on introducing an EU legislative package that allows for a restructuring and resolution of EU banks is at the heart of this debate. One reason why the equity holders and bond holders of EU banks did not face large losses in this crisis was that EU policy makers did not know how to inflict these losses without leading to a disorderly collapse of the banking system. The legislative package deals with exactly this problem and has as one of its implicit goals the reduction in public subsidies to EU banks.
The package will allow for senior bondholders to be ‘bailed-in’, meaning that if a bank loses large amounts of money, its bond holders could be subject to losses or see the bonds being converted into equity. This means that the bondholder subsidy that investors have benefited from thus far would be much lower; making the investment less attractive. There will also probably be a role for Co-Cos, contingent securities with explicit trigger points at which they will be converted into equity. Both bonds that can be bailed-in and contingent securities are largely untested instruments and the potential demand for which from banks may not be matched by the enthusiasm of investors to buy them, at least not at rates of return which are affordable to EU banks.
Recognising the increased risks faced by senior bondholders, rating agencies downgraded a number of Danish banks when Denmark introduced and used its bank restructuring legislative package in 2011. Despite the added risks, investors may show some enthusiasm for EU bank bonds and equity once the uncertainty round the final shape and timing of introduction of new regulations in general and the bank resolution regime in particular is clear, but as things stand today large uncertainties remain.
Do EU banks face a perfect storm?
Let us consider the situation from the perspective of investors that EU banks will need an approach to build up equity and fund their balance sheets.
Would you, as an investor, be compelled to put money into the heart of the Eurocrisis, at a time when banks have increased their exposure to weakening sovereigns and both the capacity and the willingness of sovereigns to support banks that get into trouble is falling?
Would you find it attractive to lend to or invest in banks that face a deep recessionary environment in their home market, where profitability is already on the decline because of structural and regulatory changes?
Would you buy bonds that could be bailed-in at a time when the weakness of the EU economy means that the likelihood of this happening is non-negligible with your only recourse in case a bank is shut down being to a relatively small part of the balance sheet – the relatively poor parts of the asset portfolios that is still unencumbered?
While the answer to any one or even two of these questions may be a yes, the likelihood that investors will play ball diminishes significantly when you put the questions together. EU banks face a perfect storm in the coming years and the only thing that can be predicted with some confidence about the future of the banking system is that it would need to look very different. No wonder then, that EU banks, Euro area banks in particular, are trading at average market values that are a third of their book values. They are facing a perfect storm.