Financial and Banking Newsletter

We analysed in May the extent to which ECB & Eurosystem funding, combined with new EU programmes such as the Pandemic Emergency Purchase Programme and the Next Generation EU Fund, are increasingly crowding out markets and becoming by far the dominant source of funding for both banks and member states.

As Europe emerges from the Covid economic slump and seeks to rebuild by deploying the multiple sources of liquidity we considered here, the main finance industry lobbying body for the UK and Europe is seizing the moment to push hard for reform of securitisation regulations. The Association of Financial Markets in Europe (AFME) seeks to water down Article 46 of the EU’s Capital Markets Directive such that banks and insurers investing in tranches of securitised bonds are required to allocate less capital than at present, thus facilitating greater leverage. This argument implicitly states that the Basel Rules for banks, and their sister Solvency 2 rules for insurers, are overly conservative and must be softened to enable this transformative, green, and sustainable recovery to take place.

We recently wrote about the extraordinary increases in debt financed by seemingly circular transactions between member state borrowing agencies and the ‘Eurosystem’ – the ECB and all the national central banks. A recent paper by Magnin and Nenovsky considers monetary data from Q4 2007 (when the financial system began to wobble) to Q2 2020. In this period, the euro area monetary base grew by 330%, money supply by 61%, and yet the CPI inflation metric was up only by 17%. Seeking to answer the question as to why such a low observable level of inflation has resulted from this “avalanche of public debt increases in the euro area”, the authors examined the institutional structure behind Eastern Europe’s socialist economies, in force for between 45 and 70 years, until ending around 1989.

The European Banking Authority (EBA) has been aware of the growing problem of non-performing loans (NPLs), especially in Italy, which quickly built up in the recessionary environment following the sovereign debt crisis from 2010. The EBA, hoping that banks could demonstrate solvency, introduced in 2014 new definitions of forbearance and of non-performance, aimed at relaxing the problem. However, despite the EBA’s efforts, Italian NPLs continued to grow at a rate of about 20% each year and peaked in 2015-16, when €341 billion, or about 17% of all Italian bank loans were classified as non-performing. In 2018 international accounting standard changes led to stricter rules requiring provisioning and loss recognition.[[IFRS9, implemented in Italy 2018]] The EBA then pressed banks to maintain more realistic valuations for NPLs on their balance sheets, making provisions which reduced profits and capital. However, these provisions were typically applied by banks to the most severe category of NPLs.

What is PEPP?

In March 2020, the ECB and European Commission announced the inception of PEPP as a ‘non-standard monetary policy measure’ to deal with the risks to monetary transmission posed by the pandemic. It is in fact the eighth eurosystem bond buying programme. Three of these have been discontinued but there are four presently running:

Late in March Archegos Capital, a New York based hedge fund, collapsed and triggered significant losses for its funding banks. The two most exposed lenders are Credit Suisse, who expect to lose $4.7 billion, and Nomura ($2 billion), but the combined losses of all its banks is estimated at $10 billion. These losses are net of $10 billion of Archegos’ cash which banks held as collateral, so total Archegos losses are $20 billion. Regulators had no idea of these exposure levels.

In February, the Bank of England (BofE) published its latest proposals for new regulations, which are openly stated to continue the implementation of the global Basel III banking standards. This 87-page Consultation Paper is presented as the next phase of reforms which respond to the 2007-8 Great Financial Crisis (GFC), the express intention of the paper being to prevent a recurrence. Buried within the array of proposals is a seemingly innocuous point:

“This chapter sets out the [BofE’s] proposal to require all intangible assets, including software assets classified as intangible assets under International Financial Reporting Standard (IFRS), to be fully deducted from CET1 [core] capital.”

Last October the ECB published a 55-page paper on the pros and cons of a central bank digital currency (CBDC). This paper concluded that research should continue at only a modest pace. It was therefore surprising that a brief statement, accelerating the project, was recently issued. We learn that the ECB (jointly with the European Commission) is actively ‘exploring the possibility of issuing a digital euro’ and that a project might commence within months. Why this acceleration? The statement mentions two factors, i) the emergence of crypto assets, and ii) ‘rapid changes in the payments landscape’. Let us consider each.

The UK’s 2019 current account deficit with the EU was GBP 118 billion. The Trade and Co-operation Agreement (TCA), commonly referred to as the Brexit agreement, is therefore of greater value to the EU by protecting this imbalance with tariff free trade, than to the UK. However, by excluding services from the Treaty – 42% of UK exports to the EU are services – key decisions about the terms of future trade in financial services such as capital markets and banking, have been deferred to this year. By carving services out of the TCA, the EU has skilfully taken the upper ground in this area. We analyse the present situation and identify possible headwinds that might limit the EU’s exploitation of this advantage.

The concept of central bank issued digital currencies (CBDC) has been around for several years, arguably since bitcoin became established around 2015. The topic is now very hot even in Europe, with Sweden planning to launch a retail focussed e-krona in 2021. Switzerland is also working on this very topic.