As QE becomes widely discredited, German policymakers end their uneasy truce with the ECB. Banking woes deepen.
Central Banks under fire for crossing the line into fiscal policy.
Claudio Borio, head of monetary and economic research at the Bank for International Settlements, recently stated that radical unconventional monetary policy “is just fiscal policy dressed up”. Not only is he correct but, more importantly, politicians are beginning to agree.
Politicians increasingly realise that these long-established policies have resulted in powerful wealth redistributional effects, generally taking from the middle and lower social strata for the benefit of the wealthier. This amounts to usurpation of fiscal policy from elected governments. “Long-established” is an important qualification. As each new “stimulus measure” was announced, central banks always explained that the particular policy was designed to provide a short term boost and would be reversed as soon as possible. However, as everybody knows, the timeframes were never met, and many commentators (such as we) remain of the view that the policies themselves were ill conceived; they could never have achieved their professed objective because neither the ECB nor the Bank of England has ever appeared to understand the true weakness, frankly the insolvency, of the banking systems under their respective supervisions.
Consequently, upon the realisation that the ECB would do “whatever it takes”, and for as long as necessary, market actors responded by bidding up the price of all fixed assets, such as shares, bonds, and real estate. Politicians generally (but mistakenly) hailed rising stock and bond markets as evidence of the strength of the economies which their governments were ‘managing’, but struggled with ever higher real estate prices, which the media called out as evidence of widening inequality.
For a year or three it has seemed that Europe has been stuck in this “doom loop” of ever looser monetary policy and ever weaker economies. As ‘populist’ political parties have gained traction so the established players have started to question the status quo. There is now a realistic prospect of a material shift in central bank policy. In a prescient recent article, John Butler called for the UK government to call a halt to the Bank of England’s improper arrogation of fiscal powers:
It would be …refreshing to see [the UK Parliament] reassert its right to determine fiscal policy more generally by telling the Bank to end QE and with it the associated insidious, pernicious distributional effects in favour of the wealthy. The economic policy focus can then turn to where it truly belongs, on how best to generate increasing rates of savings, investment and productivity growth, and in a way that does not disproportionately benefit any one group – whether rich or poor – over another.
Shortly afterwards, the UK Treasury Department confirmed that a change of policy away from quantitative easing will soon be announced, citing the perverse distributional effects and immiseration of savers discussed above.
This UK news will have been noted in Berlin. Even although German policymakers accepted the introduction of QE in January 2015 , having opposed it for several prior months, they have never endorsed it nor believed in it.
From the outset of these policies, senior ECB staff have consistently emphasised the importance of fiscal reforms being implemented by national governments. But Germany has always been sceptical and senior ECB officials have felt compelled to make pilgrimages to Berlin to answer questions and defend the policy. At the end of September, again under fire from German politicians, ECB President Draghi stuck to the same line:
“Other policy actors need to do their part, pursuing fiscal and structural policies which will contribute to a self-sustaining recovery and increase the economic growth potential of the euro area.”
No countries are heeding President Draghi’s entreaties, and the ECB is losing the argument. The rhetoric is becoming derisory. Germany’s Finance Minister Schaeuble was asked at a public meeting of industrialists to explain these policies. He quipped:
"I think it’s called QE; I don’t even know what that means."
Bank solvency now unashamedly politicised.
Deutsche Bank and Monte dei Paschi (MPS) have become bellwethers for the banking systems of Germany and Italy respectively. The media perception seems to be that if the problems afflicting these two banks can somehow be solved, then each country’s banking system will be turned around and headed in the right direction. The fate of both banks has become a matter of national importance with policymakers heavily involved, although ostensibly seeking solutions from market investors rather than public funds.
The difficulty here is that the market for equity in failed banks has almost ceased to function, as demonstrated by three recent events:
i) The size of MPS’ planned €5billion planned recapitalisation is almost ten times its present market capitalisation. Rights issues are perfectly rational corporate finance tools employed by companies to finance a new acquisition or, indeed, to boost capital when the business is struggling. An investor who had paid €100 for shares now trading at €50 may well be inclined to inject a further €30 to help keep the business afloat, judging that his chances of recovering his investment at par value (€130) are worth the risk compared with the alternative of probably writing off the €100. But no investor, acting rationally, would gamble ten times his investment in such circumstances.
ii) Most Italian banks are in trouble. NPL (non-performing loan) exposures are estimated at 15% of assets. Capital buffers able to absorb losses are estimated at about 3%. Analyst’s estimates of NPL recovery rates, or values range between 20 – 30%. So the market believes that, before provisions, this NPL overhang implies a write-down of 3 times the capitalisation of the Italian banking system. And yet, Italy has rejected the notions both of a “bad bank” and of government recapitalisations. We expect several Italian banks to ignore equity shortfalls and ‘recapitalise’ via NPL trades. The first such transaction has just been arranged for Banco Popolare di Bari. A portfolio of €471 defaulted loans was sold to a securitisation SPV (special purpose vehicle) for a price of just under €150 million. Doubts exist about this price because, although approved by the EU, the markets played a minor role in its determination. The SPV financed its purchase by issuing two notes. The senior note (85% of the purchase price) was transferred to BP Bari as the bulk of the payment for the SPV’s purchase of collateral. The junior note was indeed sold into the market, but for only €14 mm. Junior note investors were attracted by high coupons offered should NPL collections exceed investment grade base case assumptions. But, of course, this market tranche is less than 10% of the transaction price. The economic substance is that the deal is a “self-securitisation” of NPL’s by BP Bari. What are the economic drivers for the bank? By replacing seriously defaulted NPLs with an investment grade note (Baa1 – Moody’s), all of the bank’s regulatory capital ratios will be improved. Other Italian banks are expected to follow suit. Such NPL ‘sales’ will therefore provide the appearance of recapitalisation far in excess of the modest levels of cash received from sales of the junior bonds.
iii) The size of the rumoured Deutsche Bank recapitalisation (€5bn) compared to its balance sheet size (€1.8 trillion). It should be noted that the €1.8 trillion figure ignores the ‘off the books’ exposures such as derivative positions ‘hedged’ with counterparties under market standard collateral agreements. It is difficult to imagine that an injection of equity amounting to 0.00278 of the official exposure measure will provide meaningful reassurance to the array of customers and creditors who either have recently, or are today contemplating, moving their business elsewhere. Why, then, leak to the media discussions of such a trivial exercise? The inescapable conclusion is that this is about as much as Deutsche Bank can hope for, because it is without doubt deeply insolvent and without any credible profit generating business plan other than to sell assets and shed staff, like so many other struggling banks. Its Level 3 assets (defined as assets for which there is no market price) are reportedly €29bn compared with its market capitalisation of about €20 billion.
These three examples confirm our view that the likely future role of market investors in recapitalising these banks will be very small. Perhaps realisation is finally dawning on policymakers that investors have long ago ceased to believe that a number of these banks are viable. We agree.
The upshot of this is that such transactions will buy more time but only increase the pressure on the ECB to keep interest rates at around zero. The main reason for this is that for so long as the eurosystem of central bank funds is the monopoly provider of liquidity to banks, should rates rise to any meaningful positive level then the pretence of solvency which the above three transactions creates will be exposed as a sham – none of the banks would be able to afford the interest costs of funding at say 2% per annum.