The ECB must be aware that investors’ confidence in stock markets, particularly bank shares, dropped in January. If contingency plans exist, they are likely to fall short of purchasing non-performing loans.
The media consensus in early February is that most European economies are recovering, but at a snail’s pace. Despite widespread acceptance that prices of many assets are in “bubble” territory, the prevailing view is that a new financial crisis is unlikely. Respected independent commentators, such as former vice president of the Federal Reserve Bank of Dallas, Gerald O’Driscoll Jr., are of this view. After the January market turbulence he commented: “Investors have reasons to be fearful – but not terrified”. Nonetheless, he foresees problems in banking. “New capital must be injected by investors into solvent [but overextended] banks, but those that are insolvent or too weak to survive must be closed.”
The share prices of Europe’s big banks have tumbled much further than the general stock indices; after a flat to poor 2015, stock markets in the US and Europe dropped sharply early in January before modest recoveries, but remain down about 5% from end December levels. The two large Swiss banks – Credit Suisse and UBS – Germany’s Deutsche Bank and Italy’s UniCredit SpA have all fallen by around a third this year, and market conditions are so poor that the UK government suspended plans to try to sell any more publicly owned shares in Lloyds Bank plc. Even share prices of the large US banks, generally believed to be on sounder footings than their European counterparts, are down by 16% this year. 40% of European banks are trading below book value.
Why have bank share prices fallen so sharply? We would like to think that investors studied our December issue which questioned the confidence expressed by the European Banking Authority in banks, since its own report stated that 5% of bank exposures, or €1.5 trillion, are “non-performing”. Perhaps it is more likely that the selloff of bank shares reflects market awareness that they have received massive support, yet banks continue to report disappointing results, spectacular levels of “one-off” losses, and the stream of misconduct stories never relents. The increasingly pessimistic global outlook ranging from commodity and energy prices to the outlook for China and lack of growth expectations in Europe, added to investor concerns.
Further, many banks have been strongly increasing their holdings of domestic government debt, fuelling worries about the so-called “doom-loop”. In the 6.5 years from the late 2008 crisis to the start of ECB asset purchases in 2015, euro area banks loaded up their balance sheets by €770 billion of domestic government bonds. Italian and Spanish banks were the most active, trebling the level of their previous holdings. The reasons for this are fairly obvious – enhanced regulatory scrutiny of bank risk taking activities combined with the absurd classification of holdings of domestic sovereign debt as riskless.
The ECB must surely be concerned. Has it prepared contingency plans for renewed turbulence in either stock markets or problems with government debts? We suspect not, for three reasons:
a) There really is nothing more that the ECB could do, other than add qualitative easing to quantitative, i.e. Deploy its 60bn per month asset purchase programme for poorer quality assets such as non-performing loans, but this would be seen as crossing a red line by Germany.
b) Secondly, the ECB’s pronouncements reveal no evidence of any such plans. However, of course this is a sensitive subject and it is reasonable to expect that, even if plans have been made, they would be kept under wraps lest their existence might itself spark another crisis.
c) There have been few structural reforms at national level. ECB President Draghi has been careful, throughout his tenure, to remind everyone that the ECB can only manage monetary policy. National governments must enact “structural reforms” – essentially lower both taxes and public spending, or the good work of the ECB will be ineffective. However, with the possible exception of Greece, structural reforms are hard to find anywhere in the euro area.
It seems unlikely that the ECB has any contingency plans up its sleeve. As a result, the chances of a major macro event this year appear to us to be higher than they do to Mr O’Driscoll. Nonetheless, if a new crisis were to break which stressed the European financial system as severely as the July 2015 Greek crisis, provided it kept Germany in its camp the ECB could well emerge with its reputation enhanced. In order to do so it would have to enforce the new bail in rules ( if the problem was caused by a bank), or meaningfully threaten Eurozone expulsion if another sovereign default were to loom.
Recent history shows that national governments can rescue and reform their banks by establishing “bad banks”. Italy’s different approach is unlikely to achieve this.
Recent news from Italy seems to confirm our fears that, nursing non-performing loans equal to 10% of assets, its entire banking system is in trouble. Instead of enforcing the new ‘bail- in’ rules (of shareholders, bondholders and uninsured depositors) it looks as if the government is about to guarantee up to €200 billion of bad loans.
The notion of “bailing in” creditors, shareholders and junior bondholders is relatively new. Previously, it had become established practice for national governments to set up ‘bad banks’ into which the worst assets of the country’s banks are transferred. There are a multiplicity of structures, the best in our view being total separation between the good and bad banks. Managers specialising in selling defaulted loans look after the bad bank, leaving the managers of the troubled but rescued banks able to focus their energies on correcting their business models and returning their banks to profitability.
Sweden’s 1992 establishment of a bad bank arguably prevented a meltdown. Problems were so acute that the central bank raised overnight interest rates to 500% per annum. There were fears that runs on banks would leave ordinary businesses unable to trade or pay wages. Sweden’s bad bank worked. Rescued banks returned to profitability and their share prices recovered. But the cost was not cheap, taxpayers paid out about 4% of gdp to purchase the bad assets and recoveries totalled only half of the funds expended.
A more recent and even more successful bad bank was Maiden Lane, established in 2008 to acquire securities, primarily mortgage assets from Bear Stearns and AIG. This vehicle actually generated a profit of over $6 billion for US taxpayers because the securities were sold at higher prices than could be expected when the bad bank was set up. Of course, this was only possible because of the scale of the national $700 billion troubled asset relief programme and the monetary policies of the Federal Reserve itself, which boosted the prices of fixed assets.
Italy has obtained European Commission approval for an entirely different structure. Rather than establish a national bad bank, the government will guarantee the bulk of the €200 billion of defaulted loans, after they have been bundled into asset-backed securities. Even though the specific loans are described as the worst in the banking system, only bonds assessed by rating agencies as “investment grade” (ie high quality) will be guaranteed by the state, a reassuring announcement implying that taxpayer losses from calls under the guarantees will be minimised. We don’t think so, here’s why.
Italy’s plans will not require any restructuring of the banks whose assets are to be guaranteed. Further, although it is claimed that European rules prohibiting state aid have been complied with – the guarantees will be at “market prices” – the ‘market’ itself is obviously about to be boosted by the mere announcement of the guarantees. In addition, the only way that the securitisation vehicles will obtain investment grade ratings is for the underlying banks to remain exposed, by way of guarantee or repurchase obligation, for the tranches of bonds most likely to default. If, as appears likely, the rating agencies are kind to the structures and the Italian economy does not make a strong recovery, the guarantees are likely to be called.
To recap, Sweden’s bad bank probably minimised losses to taxpayers by compelling the banks, brutally and immediately, to recognise the severity of their problems. This reassured depositors and creditors; capital stopped flying out of the banks, which were able to re-access the interbank market for funding, admittedly at higher prices.
Sweden could have chosen a different path, allowing the deferral of the reporting of losses, enabling the banks involved to employ other forms of soft accounting, and removing incentives to consolidate or reform. This strategy was also rejected because investors and depositors would have shunned such banks.
To summarise, Italy’s novel approach to supporting its banks involves dealing with only some of the bad assets in a way that encourages neither consolidation of the country’s fragmented banking system (the largest 3 banks have only a combined 25% market share), nor reforms of failed business models. Despite this, Italy’s treasury officials may have one trick up their sleeve. The resulting government guaranteed securities may qualify for the ECB’s $60 bn per month asset purchase scheme. We suggested in December that the ECB might have difficulty sourcing qualifying assets, so these bonds might be welcome on that score, but should this happen market confidence in either banks or the euro itself is unlikely to rise.