Hidden cracks in the eurozone financial system threaten to derail the tentative economic recovery: the dangerous nexus between weak bank balance sheets and highly indebted corporates.
In a shot across the bows of eurozone bulls, who take comfort from well-anchored peripheral European government bonds, the IMF said, in its benchmark Global Financial Stability Report (GFSR) in October, that banks inadequate provisioning for a wave of bad corporate debt threatens growth, investment and employment prospects for years to come, without urgent redress.
Based on annual data from more than three million non-financial firms in Germany, France, Italy, Portugal and Spain, the IMF warned that many indebted borrowers are battling to service their debt particularly in the cyclical and manufacturing sectors emboldening the ECBs mission to review with rigour the health of eurozone banks in its comprehensive asset-quality review (AQR) due in October 2014.
Based on a 45% loss-given default assumption, the IMF calculated gross losses on corporate loans of eurozone banks between 2014 and 2015 assuming there is no further improvement in economic and financial conditions by mapping firms vulnerability indicators, historical default rates and debt stocks to estimate firm- and country-level probabilities of default.
In Italy, the study concludes corporate loan losses could be as high as 125 billion, exceeding banks existing provisions by 53 billion; 20 billion in Portugal, exceeding provisions by 8 billion; and 104 billion in Spain, where provisions are adequate.
The IMFs analysis showed that in Portugal 50% of corporate debt is owed by firms that have an interest coverage ratio of less than one, meaning they dont earn enough income to service their debt, compared with 40% and 30% in Spain and Italy, respectively.
The study, a corporate balance-sheet perspective, gives a sense of the scale of the ECBs challenge when it assesses individual banks balance sheets.
|José Viñals, head of the IMFs monetary and capital markets department|
It is important that banks have adequate buffers to deal with these risks, he says. In some cases, there will be a need to have corporate debt workouts that lower the debt burden of the firms to a more sustainable level.
While the negative sovereign-bank feedback loop in the eurozone has eased, the eurozone corporate sector, including banks, remains heavily indebted at 105% of GDP in the second quarter of 2013 compared with 78% in the US, according to the ECB, in part accounting for Europes lacklustre recovery relative to the US.
Many investors in European financials have long argued banks in the eurozone periphery have downplayed expected losses on their bad loan books while providing forbearance to struggling borrowers thanks to ECB life-support, aided by reluctance among some supervisors to see institutions with large loan banks write down assets.
Is the IMF report, asks Euromoney, implicitly charging that banks are playing a Japanese-style game of extend and pretend by evergreening loans, delaying the flow of eurozone credit to healthier firms?
Viñals hedges his answer: We dont have good evidence of this. There is suspicion that, in general, when you have very low interest rates the opportunity costs of evergreening is lower and, therefore, banks do it more.
But, in reality, it is very difficult to get concrete evidence of what percentage of loans are being evergreened, without having a very detailed assessment of banks.
Viñals stresses that provisioning to address deterioration in asset quality in corporate loan books could be covered by operating profits without eroding existing capital buffers.
However, low net-interest margins, and stubbornly weak revenues from fees and commissions given weak economic activity, create an uncertain backdrop for future profits for banks in Spain, Italy and Portugal.
Meanwhile, higher capital requirements, given the leverage ratio and Basels new charges in banks trading books, will surely further challenge loss-absorption capacity.
Viñals, deputy governor of the Bank of Spain between 2006 and 2009, a period in which corporates embarked on a debt binge, said precise provisioning requirements and capital needs will only be clear through a robust bank-by-bank AQR and argues the ECB should take a strict look at individual corporate loan portfolios.
Previous stress-testing and capital exercises for eurozone bank-balance sheets, conducted by the European Banking Authority (EBA) in 2011 and 2012, were subject to market doubts amid a lack of political will to stomach capital shortfalls.
Viñals says the ECB is unlikely to repeat the mistakes of past supervisors and believes eurozone governments should ring-fence public funds before the ECBs assessment is concluded.
The EBA stress test should have been more aggressive, he says. This is the past. Its water under the bridge. We need to look forward to the ECB balance-sheet assessment and stress-test exercise and ensure its thorough, deep and credible. And that it leads to the identification of capital shortfalls and that the latter are addressed with adequate capital backstops.
The ECB has all the incentives to do a good job. If problems were not identified, it would undermine the credibility of the new supervisor.
The ECBs AQR will use a harmonized definition of non-performing loans (NPLs), which would force Portuguese lenders to reclassify some loans as NPLs since the domestic supervisor applies the narrower International Financial Reporting Standards (IFRS) measure for banks accounting, according to the Institute of International Finance (IIF).
The institute warned that the eurozone corporate debt overhang could trigger a new wave of bank deleveraging while corporates, struggling with large debt burdens, will inevitably sell off assets.
In its November review of global capital markets, the IIF says: To get a sentiment of potential [bank] capital shortfalls, one has to contrast the increased NPL volumes with the risk-provisioning reserves already in place.
It turns out that Italian und Portuguese banks could be most affected by AQR and the stress tests, given high level of NPLs and below-average levels of risk provisioning.
Amid fears the negative bank-corporate feedback loop will intensify without fiscal and monetary redress, Viñals says European governments should improve corporate bankruptcy frameworks to facilitate restructurings and clarify collateral ownership rules, while, where warranted, a special asset management company could be established along with new tax or capital rules for banks to incentivize provisioning.
Viñals reckons the crisis should also trigger a shift in bank-accounting standards, since the IFRS does not permit banks to calculate provisions on possible, rather than incurred, losses.
I am a firm believer in forward-looking, through-the-cycle ex-ante provisioning, which can play an important role in addressing economic volatility, he says.
Asked whether global regulators were adding insult to eurozone banks injuries through balkanized national regulation a report published in April by Oliver Wyman estimated disjointed regulation could cost the global banking industry as much as $15 billion Viñals says there is light at the end of the tunnel within the eurozone and on a transatlantic basis.
We need to have much better cooperation between the home and the host supervisors of cross-border banks and put in place regimes to facilitate cross-border resolution, he says. If this materializes then the incentives to retreat within national borders would be much lower.
In sum, the relief rally that has gripped the eurozone in recent weeks fuelled by Ireland exiting its bailout programme in December without a precautionary credit line, Portugal emerging from recession and even Greece shrinking less than forecast masks a sobering truth: financial fragmentation remains a threat thanks to a chronic corporate-debt hangover.
In August, RBS estimated European banks will need to divest a further 3.2 trillion of assets by 2018 to fulfil Basel III rules, after eurozone banks reduced their risk-weighted assets by $1.3 trillion between the third quarter of 2011 and the second quarter of 2013, according to the IMF.
David Mackie, European economist at JPMorgan, concludes: On the basis of the survey data, growth dispersion across countries is nearly back to pre-crisis levels.
However, it has occurred with only a very modest easing of financial fragmentation, at least as evidenced in the dispersion of borrowing costs for households and non-financial corporates.
As a consequence, while we are persuaded that overall growth will continue to improve next year, it is not evident that the current degree of growth convergence will be sustained unless financial fragmentation diminishes further. Much will depend on the impact of the ECBs asset-quality review and stress tests.