The (bad) State of the European Union and its Banks

At the beginning of September I had written, 

“The Euro Area crisis has turned systemic and no sovereign or financial institution is immune to getting sucked in. The worsening problems in Greece are increasing the likelihood of a collapse of the deal agreed just in July and the large aggregate exposures of EU banks to Italian and Spanish sovereign debt have put a question mark over the solvency of individual banks as well as the EU banking system as long as these countries don’t have access to refinancing at reasonable costs.  In addition near term growths prospects have collapsed increasing the likelihood of losses on assets and lowering expected profits.” 

“Doubts about solvency and a continuing dependence of the EU banking system on wholesale funding that has a high degree of maturity and currency mis-match have cast another long dark shadow on the European banking system. Doubts about Italy and Spain, the increased likelihood of a recession, concerns about solvency and problems in the funding markets are all feeding on each other and we have in place many of the factors that can trigger a perfect storm.” 

I am afraid that too many of these dire words have come true. The Greek deal agreed in July did collapse, the worsening funding situation for Italy and Spain has started weighing very heavily on the banks that are exposed to them. At the same time, sovereigns are also suffering from the weakness of their banks as has happened with the downgrade of the Cypriot sovereign debt because of expected losses on Cypriot banks exposed to Greek government bonds. Unfortunately, on current trend, weak banks and weak sovereigns will continue to pull each other down and the sovereign-bank loop will only intensify. 

On the economic front, growth expectations have also collapsed and in fact will almost surely get even worse. This has already started weighing heavily both on weak sovereigns as well as the expected profitability of banks in the EU. 

The Euro crisis, which had already turned systemic in late August, has taken a turn for the worse beyond that and threatens to spiral out of control. The crisis has now reached the core of the Euro area and the contagion from sovereigns has now engulfed the financial system. The simultaneous problems faced by the sovereigns and banks will only get worse in the face of high legacy indebtedness and the expected recession. 

Still No solution for supporting illiquid but solvent sovereigns 

At the same time the crisis mitigation facility of the Euro Area, the European Financial Stability Facility or EFSF seems to have hit a wall and will simply not be in a position to support Italy and Spain fully no matter what it does. The limits of its ability to support sovereigns have been exposed for all to see. The European Central Bank, which has been supporting troubled sovereigns by buying their bonds through its Secondary Market Purchase program has clearly highlighted its unwillingness to scale up this support to the extend clearly needed now. We seem to have reached an institutional impasse between the incapacity of the EFSF to mitigate the crisis and the unwillingness of the ECB to do so. The pipe dreams of the BRICS and the IMF riding to the rescue of the Euro area have been exposed as being nothing more.

Political decision making in Europe remains as fraught as ever with serious co-ordination, communication and leadership failures continuing to damage confidence in the EU’s ability to solve the crisis. 

All indicators – financial, economic, political and institutional – now point to the likelihood that the crisis will get significantly worse before (if) it gets better. 

The strengthening of the sovereign-bank loop 

In the run up to the last European Council meeting, the EBA had been asked to come up with estimates of how much additional capital EU banks needed in order to restore the confidence that had been lost as a result of the stress tests not having been perceived to be robust enough. In this, the EBA followed IMF methodology marking sovereign exposures (including that on banking books) of EU banks to market and also instituting a 9% capital requirement which needed to be met by June 2011. 

There is a strong concern that by having used this methodology, the IMF and then the EBA may have reinforced the dangerous sovereign-bank loop where weak sovereigns drag down banks exposed to them and weak banks weigh on the sovereigns they are located in. By having legitimized this methodology, the IMF and EBA may now have encouraged counterparties and potential investors to also look at the evolution of the marked to market value of sovereign bond exposures for EU banks. Given, for example, that the yields on Spanish and Italian bonds have risen substantially in the past two weeks since the Euro 106 billion additional capital requirement was announced, EBA methodology shows that a substantial multi-billion Euro capital black hole has already opened in the heart of the EU banking system, particularly in the banks located in these countries. 

A related concern is that this methodology may encourage banks to offload their exposures to sovereigns especially when times are uncertain. There is some evidence that this is already happening and this dynamic is very harmful for the Euro crisis. 

Recapitalization of weak banks in weak countries remains problematic

It is clear that counterparties and non-European investors in particular are losing confidence in the EU banking system so confidence enhancing measures such as injecting additional capital are needed. However, there are important question marks over the methodology of such injections, their timing and their unintended consequences if any.

For instance, the time horizon given for raising capital introduces a period of uncertainty when the fingered banks have been put in the limelight but have not yet raised the additional funds needed. It is not clear whether the funds would be new or whether the new target capital ratios would be met through deleveraging with possible negative consequences for the real economy. And finally, given that that the majority of capital needed is for banks in member states where the sovereign itself is troubled, it is not clear where the additional capital would come from in case it is not readily available from equity markets. 

Euro area banks have lost access to term funding

Given the escalating Euro crisis, many Euro area banks have been gradually losing access to term-funding at reasonable costs. The average maturity profile of Euro area bank liabilities is now less than 3.5 years and shrinking with an increasing number of banks, particularly those in troubled sovereigns now being dependent almost wholly on the ECB for their refinancing needs. 

This is seriously problematic as this immediately drives banks towards reducing credit, increases the structural funding mis-match of the kind that helped trigger and amplify the financial crisis and stores up serious problems for any possible exit from ECB dependence. 

In the aftermath of the financial crisis of 2008 when term funding for many EU banks dried up, governments all across the EU opened up guaranteed bond issuance programs for banks and more than Euro 800 billion of bonds were issued under these. Given the funding crunch there has been increasing talk of reopening some of these programs. The problem however is that it is no longer possible for troubled sovereigns to guarantee the issuance of bonds by banks headquartered in their territory.

We are now in the midst of the perfect storm and it is far from clear when (or if at all) it will blow over. What needs to be done is very clear but the willingness to do so remains in serous doubt.