25 June 2010

Euro-zone bank's stress test: stressfull for Europe?

1. Euro zone banks in stress
 Last week European Union’s decision to publish the results of stress tests on the region’s banks was more or less imposed by the Spanish government that unexpectedly pledged to publish results on Spanish individual banks, becoming the first European government to do so.
I welcome more transparency and it is the only way to fend off rumors that markets are prone to amplify. As usual, the devil will however be in the details, the quality of the test, the amount of disclosure and the number of banks included. So far, it seems that only the tests on the 25 largest banks will be disclosed; but what about the Cajas in Spain and Landesbanken in Germany that are in trouble?
I have discussed several times challenges European countries are facing with their over-indebtedness. This is compounded by inadequate banks' shareholders funds, in particular with respect to their exposure to euro-zone sovereign debt and the private sector. The banks were indeed happy to earn a bit of extra yield on supposedly risk-free assets and loaded up their balance sheets with the weaker countries’ government debt. I doubt this debt is marked-to-market but held to maturity instead.
The market realized this, which explains the difficulty banks have to obtain short-term financing, the interbank and commercial paper markets have frozen again which translated in the surge both in short-term financing and cash deposits at the ECB in the recent past.
One may wonder who is going to buy Goverment bonds but if banks buy and immediately re-sale to the ECB  in a way to avoid no loss for banks (or pre-agreed sales at pre-agreed prices?); in some ways banks would act as an agency broker for the ECB.
Contrarily to the US, European banks on the continent did not clean their balance sheets in 2008 and have remained over-leveraged. They need to be recapitalized, then the market will be convinced that there is no longer a solvency issue.
2. French and German banks exposure
The total exposure of banks in the euro zone to Portugal, Ireland, Greece and Spain amounted to USD 1,579 billion at the end of 2009, or 2/3 of all international banks' exposure (I bet it is higher today), Spain representing nearly half of the total. French and German banks were the most exposed with respectively USD 493 billion and USD 465 billion, and USD 248 billion and USD 202 billion to Spain. The exposure of French and German banks to Greek and Spanish government debt is USD 79 billion and USD 56 billion.

The combined exposures of German, French and Belgian banks to the public sectors of Spain, Greece and Portugal amounted to 12.1%, 8.3% and 5.0% of their Tier 1 capital. By comparison, the combined exposures of Italian, Dutch and Swiss banks to the same public sectors were equal to 2.8%, 2.7% and 2.0%.
A collapse of the Club Med PIGS would be disastrous for the German, French and Belgium banking sector (please note that French banks have an exposure of USD 301 billion to Belgium, by far the largest creditors).
3. Will the dark scenario materialize?
The BIS conducted a study comparing current stress on markets with the 2007-2009 financial crisis.
The current market stress has been associated with the same increase in equity volatility as in the second half of 2007, but Libor-OIS spreads have moved up more slowly. Despite the recent rise to around 30 basis points, three-month US dollar Libor-OIS spreads remain well below their levels from August 2007 onwards. The current rise in the VIX initially followed the July 2007 trajectory, but then jumped sharply, as it did in September 2008. While cross-currency basis swaps are signalling difficulties for banks seeking to raise US dollars, the limited participation at US dollar auctions held by the ECB, the Bank of England and the Swiss National Bank suggests that the problem is more about counterparty credit risk than access to foreign currency funding. In contrast to July 2007, the euro-US dollar basis swap began the recent period at a level suggesting that stress was already present in cross-currency funding markets. The current departure point was similar to that of early September 2008, but the spread has widened by much less this time in response to worsening market conditions.
There are similarities to 2007 but not enough evidence to conclude on a soon coming crisis, based on this analysis.

The continued stress on the CDS spreads is however more worrisome:
Greece, Spain, Belgium and France are reaching new highs either in absolute terms or spread with Germany or both.

From left to right and top to bottom: Italy, Greece, Spain, Portugal, Ireland, France.

This reflects deep uncertainty about refinancing problems for Spain on markets and continued doubts about the solvency of Greece, and the impact this would have on banks most exposed to the sovereign debt of these countries.
In July, there are large euro zone sovereign financing in the turn of EUR 230 billion, including EUR 32 billion for Spain and EUR 79 billion for France (Belgium will have EUR 21 billion in September at a time when the Government should be formed; this may be tricky if the situation deteriorates in Southern Europe and France, and if the new government is not formed or if Belgium goes towards a separation between Flemish and Wallons splitting the country in two).
My guess is that stress tests will be released just before these financings to show that everything is fine with the banking sector, - oops, for the 25 banks reviewed, and what about the rest (Cajas and Landesbanken in particular)? President Sarkozy of France, said that not everything should be disclosed; if information are retained from public scrutiny, expect a new and maybe fatal down-leg for the banking sector and the euro.
The euro is a political monster and will be defended tooth and nail by euro zone politicians, like any dogma. I however believe that facts are always right in fine and therefore I expect a new crisis to emerge in Europe within the coming months, possibly as early as July.