Five years on, banks still inflict chronic pain on eurozone


Jeremy Weltman
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In light of the political turmoil in Italy affecting bond yields across the eurozone periphery, sovereign default risks have resurfaced lately. At the heart of the concern is bank stability, writes Jeremy Weltman.

When Vitor Constâncio, vice-president of the European Central Bank (ECB), delivered his speech at Chatham House this week (The nature and significance of banking union), he noted how a proposed banking union for Europe would have helped to prevent and mitigate the financial crisis. A suitably formed banking union would comprise “a single supervisory mechanism to oversee the rules and contain the build-up of risks, a single resolution authority to deal with weak or failing banks, and common safety nets to sustain depositor confidence in the event of shocks”, according to "A banking union for the euro-area," a recent IMF staff paper. However, Constâncio’s speech also made one thing clear. Progress is evidently being made to try to improve supervision and establish just such a union – alongside other “fail-safe” protection measures to prevent a recurrence of the crisis. Yet with few reforms in place, and German taxpayers growing weary of recapitalizing the European Stability Mechanism used for bailouts, bank stability is still in question, and this in turn is having implications for the sovereign creditworthiness and risk profiles of euro members. That much is clear from Euromoney’s Country Risk Survey. While some observers might still be convinced the worst of the banking crisis is over, the survey provides compelling evidence that bank stability risks are as concerning, if not worse now, for many European countries than at the beginning of last year, according to its contributing experts.
More than five years on from the catastrophic events of 2007/08, the resolution of the region’s banking sector problems is still firmly at the top of policymakers’ to-do list, but with plans seemingly stalling, the implications of failing to act could prove critical. A recent article in Emerging Markets (Eurozone debt crisis risk ‘most immediate’ for banks), quoting Moody’s, highlighted such warnings. Balance still tipping toward score downgrades Bank stability – one of 15 economic, political and structural factors used to compile the overall ECR risk scores – ended 2012 at dangerous levels for many countries, the Euromoney survey suggests. Scores for the bank stability indicator were marked down by economists and country-risk experts for nine out of 17 eurozone countries last year, and it will be interesting to note if any more changes occur when the next quarterly aggregation takes place, the results of which will be available early next month. Previous ECR research (More of the eurozone drawn into bank crisis) has highlighted the close correlation between bank stability risk and the risk to government finances, as taxpayers are dragged into footing the bill to clear up the mess. As the updated chart (below) demonstrates, countries with low bank-stability scores are highly correlated with low scores for their government finances, and vice versa.
Bank stability has become concerning, too, for Denmark – still a stable triple-A sovereign – and the UK, residing in the second of ECR’s five tiered groups, which suffered the ignominy of losing its triple-A status from Moody’s last month. The two countries, still using their own currencies – though closely linked to the euro in Denmark’s case – and integrated through trade and capital flows to the single currency area, saw their bank stability indicators downgraded by 0.6 points each in 2012. Across the eurozone, bank stability risks were unchanged last year in four countries – Austria, Belgium, Cyprus and Slovakia; with Cyprus the lowest of the group – and improved in four more: Malta, Italy, Ireland and Portugal. However, for the latter three, the rebounds were small and their scores remained at low levels of 5.5, 4.3 and 3.3 out of 10 respectively, illustrating heightened levels of risk. Tier-one Finland, lying in sixth place out of 185 countries on Euromoney’s global risk data table, could still boast the safest eurozone banking system last year. Greece, a tier-five sovereign languishing in 110th spot, was undoubtedly the riskiest – its bank stability score differential was unaltered at 5.6 points. Outside the eurozone, banking systems in Sweden, Latvia and Lithuania were assessed as safer by economists and other country-risk experts, pointing to their more limited exposures and contagion threats. Luxembourg, still a comparatively safe financial jurisdiction – and ranking second overall to Norway, ECR’s safest sovereign – saw its bank stability score slip by 0.5 points last year, the same as France. However, Spanish bank stability risk increased by more – a 0.8 point drop last year, reducing the score to an alarming 3.5 out of 10. Spanish bank woes crippling eurozone resolution Undoubtedly, there are political dimensions to the Spanish crisis. The risks attached to Spain’s institutions, its regulatory and policy environment and the prospects of repatriation/payment by the government, all increased last year (scores fell), and the government itself has lately become implicated in a corruption scandal. However, it is concerns for bank stability that are driving the deterioration in its economic assessment – the factor that has been marked down the most by Euromoney’s Spanish experts. The government has made efforts to restructure and deleverage the banking system, and liquidity constraints have eased, prompting the European Commission (EC) to issue encouraging statements to suggest the bank reform programme is on track.
Sareb, a bank debt resolution company, has been established to separate the assets of state-aided banks. However, the EC notes it lacks a sound business plan, that supervisory procedures still need to be reviewed and a reform of governance of the savings banks should be agreed. All the while, the backdrop of very weak growth is undermining loan quality. Credit default spreads, though down on their mid-2012 highs, remain volatile even for the larger and more stable banking groups, such as BBVA and Santander (see chart). And the impact on Spain’s fiscal metrics is clear. The government announced recently that its general government deficit was 6.7% of GDP in 2012 – which is still worryingly high, despite the satisfaction of ameliorating cyclical and structural deficits, and progress in containing the deficits of the autonomous regions. However, this outturn failed to account for the costs of bank recapitalization, which bumps the deficit up to just above 10% of GDP. The government is hoping this will be retroactively mutualized once the ECB becomes the eurozone’s supervisory authority, but that is taking some time to agree and might not reach fruition at all. Some eurozone members – Germany included – are opposed to the direct capital injections that would remove the national debt implications of governments seeking loans to support their financial systems, for fear of stoking moral hazard and burdening their own domestic taxpayers. Bank stability wider problem Still, the worst deterioration in banking sector risk last year occurred for tier-three sovereign Slovenia, with its bank stability score slipping 1.2 points to 5.0. In the process it became more risky for that particular facet of sovereign risk than Belgium, Cyprus or Italy. The problems in Slovenia were given considerable attention on ECR’s research platform last year (see, for example, Slovenia leads rise in bank stability risk across Europe). One of ECR’s contributors, Ales Pustovrh at Bogatin Consulting, in conjunction with Marko Jaklic at the University of Ljubljana, delved into Slovenia’s banking sector problems (Is Slovenia next?) and found some worrying signs. Rated A- by Fitch, Slovenia’s investment-grade potentials have slipped in concert with Italy’s.
And the banks are just as problematic across the periphery. Taken as a whole, the seven riskiest eurozone countries (Greece, Portugal, Spain, Ireland, Italy, Cyprus and Slovenia) had an average bank stability score below that of most other regions, worse even than Mena or Latin America – see chart (below). And that was as of December 2012, some three months after the ECB announced its outright monetary transactions (OMT) programme and amid other measures that have been taken since the 2007/08 blow-out, to boost liquidity and increase capitalization.
However, while European policymakers have been discussing more safeguards, little of substance has been put in place, and many governments are still grappling with huge, black financial holes made worse by contracting economies. Few eurozone sovereigns are expected to register any growth at all this year. The latest (March 2013) Eurozone Barometer, a monthly poll of independent forecasting experts, predicts another year of contraction for the eurozone in 2013 as the interminable declines in Italy, Spain, Greece and other countries continues. These risks might jolt policymakers into action. That is the hope of Jens Weidmann, president of the Bundesbank (Germany’s central bank), who has lately implored the EU to accelerate its reform efforts to avoid plunging Europe into further financial chaos. Weidmann is calling for a “bail-in” process of resolving failed institutions, to place more of the burden of default on the banks’ shareholders and creditors rather than taxpayers, and has signalled that bond markets will start to punish sovereigns again if the reform process buckles. His concerns are driving the Bundesbank to build up financial reserves in response to the additional risks assumed by the ECB and the eurosystem of 17 national central banks, as it extends low-cost crisis loans to the commercial banking system. Those risks would be compounded if the OMT programme – an offer to purchase debt to secure manageable borrowing costs for distressed sovereigns – is carried through. While Europe awaits more concrete proposals to restore confidence, ECR experts, it seems, are still to be convinced that the banking system is on a clear path to recovery.

This artice was originally published by Euromoney Country Risk. To discover more, resister for a free trial at Euromoney Country Risk