The pernicious backdrop for the European banking system is clear: looming sovereign debt write-downs; a stubbornly long recession that’s savaging banks’ asset quality; and the effective closure of private funding markets for banks, principally equity markets for rights issues and the senior unsecured bond market. And yet European regulators are in self-congratulatory mode, claiming that 27 banks estimated last autumn to have a capital shortfall of €76 billion had raised a combined €94.4 billion by the end of a June deadline. The European Banking Authority (EBA) reckons that by reduction in risk-weighted assets, government support or capital-raising in the markets, the regional financial system is in a stronger position - even as banking apologists baulk at pro-cyclical regulation and haircuts on sovereign debt at a time of an unprecedented government debt crisis.
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| Andrea Enria, chairperson of EBA |
But even without fully factoring in the negative sovereign-bank feedback loop ex-Greece, Ireland and Portugal, fears remain that the EBA’s estimates last year of Europe’s bank capital needs failed to take into account the worse-than-expected regional recession year-to-date. That’s the conclusion at least from Joseph Kalish, chief macro strategist at Ned Davis Research. In October 2011, Kalish estimated that capital needs for the banks in the 17-member eurozone totalled €345 billion (3.7% of 2011 GDP). His conclusions were in stark contrast to the EBA’s estimates and were based on a profound difference in methodology.
For good reason.
A chief complaint from bank analysts about the EBA’s financial stress test last June was the curiously benign treatment of the coverage ratio. After all, the median coverage ratio of the 90 European banks examined in the test was around 38% to meet the 9% core tier 1 capital ratio target. By contrast, US banks had a coverage ratio of 67% in the first quarter of 2011, according to the Federal Deposit Insurance Corporation. This means that at the time of the European banking stress test, US banks had a coverage ratio three-quarters higher than for European banks. Of course, given the tragi-comic nature of global banks’ earnings in recent years, a high coverage ratio always gives banks an incentive to cut provisions to artificially boost earnings. But the case for high coverage ratios, which indicate the amount of reserves bank have set aside relative to non-performing loans, is clear. Given the amount of distressed assets in the real estate sector, in particular – as the example of Spain dramatically lays bare– high coverage ratios serve as the crucial buffer.
With some prescience then, factoring in a 67% coverage ratio, Kalish estimated last year that Spain’s banking system faced a capital shortfall of €101 billion – nearly identical to the €100 billion of aid recently requested by Spain for its bank bailout. Kalich added in estimates for sovereign haircuts for Greece, Ireland and Portugal, in aggregate, although he did not apply sovereign haircuts’ estimates to individual banks.
(Other methodological differences between Kalich and the EBA’s estimates include the fact that Ned Davis Research calculated core tier 1 ratios, estimated at the end of 2012, to factor in a more economically distressed environment, rather than the EBA’s reliance on recorded second-quarter 2011 values.)
In sum, Ned Davis Research estimates, in hindsight, were probably more realistic than most. Against this backdrop, take note: Kalich fears that the next two eurozone banking dominoes to fall are Italy and Slovenia, as the domestic banking systems’ capital needs in relation to GDP last year were just some two percentage points lower than the fateful 6% – a point at which sovereigns have requested external assistance.
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Two conclusions appear from the above graph. On the upside, aside from Italy and Slovenia, the remaining sovereigns do not appear to be in any imminent trouble from a bank-financing crunch, Kalish says. Secondly, the EBA said last year that Italy’s banks have the third biggest capital shortfall, after Greece and Spain, at €15.4 billion – the majority of which has now been addressed, suggests the EBA. NDR estimated last year, however, the country’s banks had a capital shortfall of €64.5 billion, based on a more-realistic coverage ratio.
Italy debt clock
And risks are rising. In Italy, the sector-wide NPL ratio is up by around 25% since the start of the year, with corporate NPLs at 8.0% compared to a system-wide average of 3.1%. Coverage ratios have also declined from a low base, with the system-wide NPL coverage ratio having declined to from 52% in 2008 to 41% now – uniformly. UniCreditand Intesa, for example, can both boast coverage ratios above the average judging from Q1 results, with the former reporting a coverage ratio of 57.1% and the latter 45.5%. But this leaves even the most solid looking Italian banks looking underprovisioned compared to even Spanish banks: CaixaBank reported a coverage ratio of 61% in its Q1 results, for example. The big question is what will happen with non-performing loans in Italy and elsewhere. If NPLs fall the coverage ratio will increase automatically but the opposite scenario highlights the potential for a capital shortfall in Italy to roil markets at a time when public funding markets are barely open.
The second monster in the closet is that NDR’s estimates included sovereign debt haircuts only from Greece, Ireland, and Portugal. “There were no haircuts for Italian, Spanish, or any other sovereign debt. Any restructuring of this debt would further decimate the capital positions of these banks and would require additional aid,” Kalich notes.
And the clock is ticking. As we have reported, if Canadian ratings agency DBRS becomes the fourth ratings agency to downgrade Spain to a BBB-rated equivalent, a 5% increase in the haircut the European Central Bank demands for Spanish government bonds will be applied across the board, affecting some €250 billion of bonds pledged by Spanish banks to the monetary authority – as well as other banks holding Spanish government debt. What’s more, without a third round of the ECB long-term refinancing operation, Italian banks might deleverageby up to €444 billion during the next two years, intensifying the negative sovereign-bank feedback loop. And yet fears are growing that in Italy, as in Spain, the real rate of government debt interest payments will leap above the real rate of growth, exacerbating the economy’s already high debt-to-GDP ratio at 120%.
What’s more, ascertaining the number of prudent loan-loss provisions against an identifiable pool of defaulted assets is the easy part. Low interest rates have artificially boosted asset prices, moderating the pace of new NPL creation, but fears are growing that the ECB is stuck in a so-called “liquidity trap,” whereby nominal interest rates can barely fall lower, and weak aggregate demand will continue to haunt banks’ loan banks. Markets are eagerly awaiting the EBA’s report to guage just how much progress has been made on banks’ capital needs amid multiple headwinds – NPL pressure, weak bank funding markets and sovereign debt write-downs.
With the eurozone economic and political crisis intensifying, and the ECB so-far refusing to publicly target government bond spreadsand Berlin rejecting intra-regional fiscal transfers – the only two game-changers in town – claims that European banks are on a strong capital footing might prove wholly premature.