12 August 2011

Hey Europe, What Is Going On? (Part 3)

We ended Part 2 of the current series with a promise to provide a refreshing look to the European banking sector. Understanding this is essential in order to grasp the full extent of challenges facing Europe. Why?

Because financial sector is not private sector; it is private sector only in good times but in bad times banks are supposed to be bailed out by central banks, governments and ultimately by tax payers. This is by design so due to the liquidity risks that banks take, their interdependence, the deposit guarantees that governments provide and the role that financial sector plays in our economy. Occasionally some banks are allowed to fail but rather they (especially larger ones) become a burden to public sector if in difficulties. The later may be a deadly hit to a country’s public finances.

What aggravates the issue is that financial markets are integrated but only partly so. In good times banks act as global players with no considerable restrictions. Thus they can grow far beyond the economies of their home countries. In bad times however those are the home countries that have to deal with the consequences, at least before a sovereign’s debt crisis becomes a broader issue (as has happened with Ireland for example).

On the other hand, while acting as creditors, some banks become highly exposed to the risks in other countries, incl. the sovereign default risk. When we are talking about a too-big-to-fail bank highly exposed to Ireland for example, it is in the interest of the home country of that bank, not to allow Ireland to default. More precisely, the “home country” faces two bad choices: whether to participate in the bailout operation of Ireland or to bail out its own banks later on. The resources for both obviously are limited. Often participation in a coordinated operation is cheaper as it is built more on promises than on real money.

Generally speaking, Europe’s banking sector is characterised by the following:
* Several banks are very large when compared to the economies of home countries. On average, banking sector assets exceed countries’ GDP figures by more than twice (see Figure 1 below).
* The banking sector is highly leveraged while displaying rather good regulatory capital ratios at the same time. This is “thanks” to the implementation of advanced risk measurement approaches (as IRB for calculating capital for credit risk) as a result of which risk-weighted assets (RWA) are rather low when compared to the total exposure.
* Many banks have the so-called legacy portfolios (or the non-core businesses) that they are trying to get rid of. Some record large losses because of that.
* Whenever possible, low exposures towards PIIGS countries are being stressed. The others are trying to diversify away geographically. Smaller local players are stuck and therefore experience serious funding problems.
* Governments already own large shares in several banks (Irish banks, RBS and Lloyds Banking Group in UK, and ABN AMRO in the Netherlands when just to name some examples).
* While stressing strong balance sheets (a statement the truth value of which is a big question mark as we shall see), several banks are now clearly willing to focus on profitability and (selective) growth; this however is hindered by the second wave of market disturbances, economic slowdown and the “legacy assets”.


Some selected balance sheet and capitalisation indicators for the largest European banks displayed in Figure 2 below reveal how vulnerable the European banking sector actually is. When looking at this picture, one my even get an impression that it is a new norm to run a balance sheet with barely 3% of loss absorbing capital. Come on! Considering how subjective the valuations and provisioning of the assets are, and how large are the movements in asset prices right now, we may well say that these banks are the same as defaulted already. It also appears to be a new norm that banks lend more than they have deposits, and that they have cash around 1% of liabilities or even less. Less than 1%!!? Even if the rest of the liquidity reserves is in AAA-rated government securities, it is too little as an AAA rating too often does not actually mean an AAA rating (for reference, consider the implications of the recent US rating downgrade by S&P, and the buzz around it).

(Click for larger image)

Based on the above simple analysis all the largest European banks are on the verge of failure save for HSBC and, surprise-surprise, the two Spanish banks perhaps (the first of which is exposed to the risks arising from the “funny assets” and later of which face other challenges arising from the exposures to Spanish and Portuguese counterparties). It is just unbelievable how far we have moved from what the common sense would suggest as reasonable level of risk taking. Isn’t it amazing that by such numbers the very same banks dare to argue that they are well prepared for another stress? How can a financial system function like that? The answer is that thanks to the explicit and implicit, direct and indirect guarantees by the governments and the other (international) public sector funds and organisations.

The comparison of Core Tier 1 (CT1) capital ratios and the ratios of CT1 to total assets are worth a comment too. Namely, banks with stronger CT1 capital ratios love to present on press conferences and analyst meetings the comparison with peers based on this indicator. However, as we see from the examples of UBS, Credit Suisse, Deutsche Bank and some others, strong regulatory capital ratios do not certainly mean (and often they do not mean) strong capitalisation. They rather refer to the low risk-weighted assets when compared to the total assets (see column “RWA / Total assets” in the Table above). It appears that this ratio tends to be especially low for two types of banks:
1) those that have rather low proportion of loans and large proportion of every kind of other instruments (part of them pretty funny) in their balance sheets (the abovementioned UBS, Deutsche Bank and Credit Suisse), and
2) those that have low historical default experience e.g. as a result of the social safety nets (e.g. Swedish banks).
Both cases reflect the limitations of statistical modelling and model assumptions rather than provide sufficient justification for maintaining that thin capital base. The other banks with lower CT1 capital ratios (Erste Bank Group, for example) are stressing just that: that the quality of their capital ratios is better because RWA is higher when compared to the total assets. Among others, regulators (such EBA, the Danish FSA and apparently also Riksbank) have also become concerned about the differences between the risk weights of individual banks that cannot be explained with the differences in underlying exposures. The short summary is that CT1 capital ratio is not a good enough indicator of a bank’s capitalisation.

An overview of the geographical distribution of banks’ exposures for the top 20 European banks based on the data from EBA stress test is provided in Figure 3 below. Exposures (more precisely, EAD which means Exposure at Default numbers) to each country/region are displayed as percentage of the banks’ common equity. We have only included non-defaulted exposures to exclude from our analysis the losses that have been taken by the banks already (this is a simplification of course, but it gives an idea at least). In addition, you can also see the size of each bank’s assets relative to the home country’s GDP.

 (Click for larger image)

The first thing that everyone is looking for, is a bank’s exposure towards the so-called PIIGS countries (or GIIPS countries – the acronym used by those to whom “PIIGS” reminds too much certain domestic animals) Greece, Ireland, Portugal, Italy and Spain. We can see that:
* The exposures towards Greece are more-less controllable for the largest European banks (which is not true for the Cyprus’ banks however). As of 31 December 2010 they formed less than 50% of each bank’s common equity; in the results of Q2 2011 a 21% loss for Greece’s government bonds with maturities before or in 2020 is already recognised.
* For some banks (notably for Danske in Denmark, KBC Bank in Belgium and RBS in UK, as well as for a punch of Germany’s banks) additional significant losses from exposures towards Ireland may prove to be very challenging to bear, especially if market conditions remain tough, interest rates remain low or drop even further and thus the level of earnings cannot be preserved. The same applies for Spanish banks’ exposures towards Portugal (only Banco Santander is highlighted in the table above, but it’s not the only one if we also take into consideration smaller banks).
* More-less all large French and Germany’s banks as well as Belgium’s banks (and naturally, Spanish and Italian banks) are too exposed to Spain and/or Italy to handle serious troubles in these countries; this would be extremely difficult even if more general panic triggered by the problems there could be avoided somehow.

What concerns other regions then we see that European banks are expanding to all over the world, although currently still mostly exposed to the developments in Europe and US, and in Latin America when it comes to Spanish banks.

To conclude this analysis, we can say the following.

It sounds ironical, but central banks and financial supervisory authorities of European countries have succeeded in at least one thing: making European banks dependant from themselves. There would probably be very little of those ready to provide funding to several of the French banks for example, if there were no guarantees in place (also positive stress test conclusions serve as implicit guarantees). Yet when the reliability of such guarantees becomes into question... Well, ending this sentence should not be too difficult. As an illustration, within less than one month up to the date (August 11), the share price of Societe Generale has fallen by 40% for example, and the share price of Credit Agricole by more than 35%. Of course, short selling, herd behaviour and general market panic have become into play, and France has still preserved its AAA rating (justified or not), but these numbers still provide an indication.

It is possible to “sacrifice” Greece in the name of the “One Europe” project and maybe (although dropping this country is much less likely) Portugal. Yet Ireland is in the eurozone to stay. Every such kind of decision now requires “fine calculations”. Here France and Germany might reach an agreement as the banking sectors of both countries face similar challenges at the end.

Is eurozone itself to be preserved? Well, the size of European banks relative to the home countries’ economies implies that this is rather more than less likely. Furthermore, Prison Planet or not, but moving towards one single global central bank and one single (financial) regulator is clearly set in. Global banks and even more global highly risky banks require global (resolution) framework. Again, if the complete collapse of Western economies is avoided (for which, despite of everything, serious efforts are being made).

Up next in this series: interdependences within Europe

5 comments:

  1. European banking sector is really in my opinion at less risks in comparison to other banks and I hope it will survive against all obstacles created by crisis.

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  2. I'd appreciate your reasoning; it would be interesting indeed to read. Best,

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  3. I had read your 1st and 2nd part both about the European banking sector and now the 3rd part is also awesome.You know how to present the truth with straightforward attitude. I am highly impressed.

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  4. Information is written about Euroean banking Scots .It will have less risskj involved as compared to other banking sectors.

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  5. This is by design so due to the liquidity risks that banks take, their interdependence.

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