The quest for a healthy European banking sector

Yesterday saw the release of the hefty Liikanen report (a dense 153 pages) on the European banking sector. We’re yet to fully sift through the report but there a quite a few eye catching graphs and statistics which we thought worth flagging up.

In brief, the Group recommends actions in the five following areas:

• Mandatory separation of proprietary trading and other high-risk trading activities. 
• Possible additional separation of activities conditional on the recovery and resolution plan. 
• Possible amendments to the use of bail-in instruments as a resolution tool. 
• A review of capital requirements on trading assets and real estate related loans. 
• A strengthening of the governance and control of banks. 

Many ideas which will be familiar to those in the UK and there are plenty of reasonable suggestions - which we'll return to. We would note though that in Europe even small banks caused problems while the largest banks which caused the initial financial crisis were investment banks with no retail element. In some cases better supervision and enforcement of regulations is more important than the actual structure of the banking sector itself. But for now, take a look at these graphs - from the report - which raise some interesting questions over the proposition of a eurozone banking union:

The table and graphs above demonstrate the simply massive size of some of Europe's banks, even in comparison to those in the US and Japan. This drives home the fact that, for a banking union to ever really work or be effective there must be combined deposit and resolution fund backing it up, something which the eurozone is now shying away from. This is also a much larger decision than the eurozone is currently making out the banking union and single supervisor creation out to be.

Some preliminary thoughts on the stress tests for Spanish banks: lots of optimistic assumptions...

Here is the full report (and the bank-by-bank results) from the latest Spanish bank stress test exercise. Below we provide the key points and our initial thoughts on them.

The tests put the total capital needs of Spanish banks at €59.3bn, but Spanish Deputy Finance Minister Fernando Jiménez Latorre (in the picture) just told journalists during the press conference that, assuming that Spanish banks manage to raise part of the money from other sources, the Spanish government could ask the EFSF for "around €40bn" (as we anticipated here).

Key points: 

• 14 banks assessed, 7 found to be well capitalised, 7 found to need capital injection. Total needs put at €59.3bn. This falls to €53.75bn when the mergers under way and the tax effects are considered;

• €24.7bn of the total amount is earmarked for Bankia alone, with a further €10.8bn for CatalunyaCaixa and €7.2bn for NovaGalicia;

• The adverse economic scenario assessed was: 6.5% cumulative GDP drop, unemployment reaching 27.2% and additional drops in house and land price indices of 25% and 60% respectively, for the three-year period from 2012 to 2014;

• Cumulative credit losses for the in-scope domestic back book of lending assets are approximately €270bn for the adverse (stress) scenario, of which €265bn correspond to the existing book. This compares with cumulative credit losses amounting to approximately €183bn under the base scenario.

Open Europe take: 

• The base case scenario seems overly optimistic, the adverse scenario looks more realistic - although we expect a fall in house prices of around 35% rather than the 25% assumed. The prediction that unemployment will peak at 27.2% also seems optimistic given that there is plenty more austerity and internal devaluation to come while the structural labour market reforms are yet to take effect.

• Oliver Wyman's report strongly assumes that all the previous capital buffers and loan loss provisions have been well implemented with suitable quality of assets. However, this is far from assured;

• The level of non-performing mortgage loans seems incredibly low at 3.3% currently with losses only predicted to rise to 4.1% under the adverse scenario. This number could well be distorted by forbearance (delaying foreclosing on loans likely to default to avoid taking losses) by struggling banks. It will also massively increase if unemployment and economic growth turn out to be worse than predicted;

• The levels of recovery on foreclosed assets seem a bit too positive (admittedly a wide range of between 37% - 79% losses depending on type of asset) given the continuing oversupply in the real estate market in Spain. Until the market has fully adjusted, the huge mismatch between supply and demand is likely to keep resale value on foreclosed assets incredibly low;

• These tests do look to be more intense than the previous ones but ultimately the optimistic assumptions do instantly raise questions over their credibility. The structure of the bailout request is also unlikely to enamour investors, who like to see grand gestures, however, it always positive that taxpayer participation may be limited. 

 

So Bankia is still a viable bank...?

Spain announced its plans for cleaning up its banking sector earlier. With the full legislation only just released, we are still looking through it and will bring you the pertinent points in due course. But there was also another interesting development with regards to the ailing lender BFA-Bankia.

The Spanish government announced this afternoon that BFA-Bankia will receive an "immediate capital injection" from Spain's bank restructuring fund (FROB). Nonetheless, Spain has decided not to request the early disbursement of part of its €100bn bank bailout package. This is despite the fact that €30bn had been set aside for emergencies, as the Eurogroup noted in a statement issued earlier this afternoon. The funds will therefore be paid out in advance by the FROB and will be eventually incorporated into the Spanish bank bailout when it is fully dispersed.

This raises a couple of interesting questions. Firstly, why is Spain so keen to avoid tapping the €30bn kept in reserve? The money is there for just such an occasion, and in fact it was fairly obvious that this exact situation would arise. What's more, the money will be folded into the bailout anyway. Therefore, we can only imagine that the Spanish government is keen to avoid some kind of negative stigma – although this seems slightly strange since the bailout is already confirmed. It is worth keeping in mind the constraints of the EFSF vs. ESM funding (which we covered here), so it is possible that Spain and the eurozone have decided they want to wait until the ESM is fully operational before tapping the funds.

Reading the press release, it is also clear that this is a restructuring of BFA-Bankia, meaning it is still viewed as a viable bank. This seems almost outrageous for a few reasons:

• Bad loans held by Bankia jumped by 44% (to 11%) in the past six months alone
• The group just posted a loss of €4.45bn, compared to a slight profit a year ago
• In the past six months the banking group has lost a staggering €37.6bn in client funds, a massive 28% fall. 

It’s been clear to most for some time that Bankia is no longer viable. The latest government plans for dealing with the banking sector provide for an “orderly resolution” of unviable banks and a template for splitting up its assets and winding down the institution. It is not entirely clear why this is not being applied here, although protecting retail investors could be part of it. In the end, though, investing further public funds into a failing institution will do everyone more harm than good.

A eurozone banking union will fundamentally change the rules of the game for Britain in Europe: Is Cameron ready to pull another veto?

Over on the Telegraph blog, we argue:

Talk of a banking union for the eurozone has become fashionable. Many, including the British government, see the idea as a way to provide some sort of backstop for the eurozone, where shaky banks remain a huge threat not only to the single currency, but also to the British economy.

Banking union, as a concept, has merits – it tries to deal with the ever elusive question: what happens when cross-border banks fail? But, viewed from London, a banking union is also political dynamite. It cuts to the heart of both a key national industry and Britain's future place in the EU as the eurozone integrates further.

There are only embryonic proposals on the table at the moment, and a lot is unclear. A banking union could involve a wind-down mechanism, resolution fund and deposit guarantee scheme – all on a cross-border basis. It could also take various different institutional shapes, putting the Commission, the ECB or national capitals respectively at the centre (expect turf battles). All of these vital decisions will take a lot of negotiation and time to sort out and may involve EU treaty changes – while there’s huge resistance in some member states, not least Germany. It may not be politically possible to achieve.

Regardless, the UK cannot take part in the banking union itself: politically, it would involve a massive transfer of powers to the EU, which no British government will go anywhere near. Economically it would be virtually impossible too, given the disproportional risk accounted for by the City of London, which neither side would be willing to accept. Instead, in a scenario reminiscent of David Cameron’s December veto, the question is whether London will simply nod through the changes (whether a Treaty change or not, the UK will have veto over at least some elements) or whether it will name a price for its approval.

George Osborne and No 10 have said they will seek safeguards to ensure that “British interests are secured and the single market is protected… anything affecting the single market should be agreed by all 27.” But is Cameron really willing to veto the same union that he is calling for?

Because if, according to UK wishes, a fully-fledged banking union indeed materialises, it’s very difficult to see how it would not cut right across the single market. The most obvious risk is over ‘location policy’ – whether in future a certain firm or financial activity must be supervised by eurozone authorities in order to do business there. This would essentially serve as a massive barrier to UK firms doing business in Europe – in an extreme case, the City of London would effectively become ‘offshore’ for the purposes of trade with euro countries.

But more probably, for a banking union based on cross-border liabilities to really work, it would need to be backed by perfectly harmonised regulations, to avoid a bank in one country essentially free-riding off the back of guarantees by taxpayers in another country. This is precisely why the Germans are so sceptical – without a single set of rules the banking union would spill over to fiscal union but without the corresponding central controls. Not only because backstopping banks is a big part of state liabilities, but also because banks flush with new eurozone-wide guarantees could lend to their domestic sovereigns at incredibly low rates, essentially providing artificial subsidies to states and removing market pressure for reform (sound familiar?). That would give rise to moral hazard of ridiculous proportions.

Instead, the eurozone will need a ‘single rulebook’ for banks, which may or may not be compatible with the current rules governing the single market in financial services. For example, to counter free-riding risks, individual countries could have no discretion whatsoever on capital requirements for banks. It would be a single target for all euro countries, with zero flexibility. This may not be a disaster for the UK – it could even be a benefit. But it could also go the other way, ending with an in-built eurozone majority voting to apply the single eurozone capital target for the EU as a whole, which could be substantially different to the needs of the UK. A eurozone banking union would also alter the basic relationship between the home and host countries of cross-border banks (i.e. subsidiaries), shifting the previous fragmentation from national borders, to the euro/non-euro divide.

Again, this may or may not be a problem for the UK, but the point is that inherent in the creation of a full-scale banking union is the fragmentation of the EU single market – which means that, if you’re sat in London, you should tread extremely carefully around the issue. A compromise may be possible (though it won’t be pretty) which would allow for the gap between the eurozone and the single market to remain narrow (we’ve suggested some potential compromises here). But the political dilemma for the UK government is clear: is it prepared to use another veto to block a banking union absent UK-specific safeguards – risking being perceived as hampering efforts to save the euro? Or will it simply nod through potentially game-changing proposals, risking the wrath of its backbenchers?

Do not adjust your television set, this is not a Spanish rescue (despite looking an awful lot like one...)

Well, that was the line that Spanish Economy Minister Luis de Guindos was spinning yesterday. Sorry Luis, this is essentially a Spanish rescue - external funding sources filling a gap which the state can't (check), monitoring of a large chunk of the economy (check), involvement of all the big international organisations (check - EU, IMF, ECB etc.), the list goes on.

Meanwhile, the oft absent Spanish Prime Minister Mariano Rajoy held a press conference today, declaring the package a 'victory' for the euro and stating that if it were not for the current government's reforms it would have been a full bailout package. If this is a victory (finally dealing with a glaring problem after four years) then we don't want to see a defeat, but at least Rajoy made a public appearance this time. That said, in the midst of the worst crisis his country has faced since the financial crisis hit, Rajoy is now jetting off Poland to watch Spain vs. Italy (a mouth watering prospect admittedly but his timing could take some work), while the likes of the Education Minister are heading to Roland Garros to watch Rafael Nadal - the Spanish government not quite in crisis mode then, we're not sure if that should inspire confidence or not...

In any case, as we predicted over two months ago, European assistance to help Spain deal with its banks is now official, so what does this rescue mean for Spain and the eurozone, below we outline some of the key points and our take:

The plan
Spain will access a loan from the EFSF/ESM (the eurozone bailout funds) which it will use to recapitalise its ailing banking sector. The money will be channelled through the FROB (the bank restructuring fund) but will still be a state liability (it will not go directly to the banks). However, unlike the other bailouts it will not come with fiscal conditions but only conditions for reforming the financial sector.

Open Europe take:
Firstly, the ESM will not be in place in time to provide the loan (the treaty is yet to be ratified by numerous countries and has faced many delays) so at least initially it will come from the EFSF. As others have pointed out, this is important because ESM loans are senior to other types of Spanish debt while EFSF loans are not. This may make things easier to start with (as it removes the threat of legal challenges based on clauses in other Spanish sovereign debt which could be triggered if it suddenly became junior), however, Finland has already raised concerns over its exposure and role in the rescue - an issue we tackle in more detail below.

The lack of additional fiscal conditions is fair given that Spain is already subject to a deficit reduction programme and that this is ultimately a financial sector problem. There are questions over conditionality and moral hazard though - we would like to see bank bondholders and shareholders sharing more of the burden (bail-ins) to ensure the necessary reforms take place. As things stand its hard to see how the banks will 'pay' for this capital, particularly given the Spanish regulators previous failures (during and after the property bubble).

De Guindos confirmed that the funds would be counted as Spanish debt, so Spanish debt to GDP could be about to jump by 10% in the near future and given its current path this could put Spain over 90% debt to GDP (the level beyond which sustainability becomes questionable) much sooner than had been anticipated. This will require adjustments in its reform programme and lead to increasing market pressure.
 
Size - is it enough?
This is the key question - the total amount has been put at "up to" €100bn. That is much higher than was suggested by the IMF assessment released on Friday night, which suggested €40bn.

Open Europe take:
It sounds like a big number, but upon closer inspection it may not stretch as far as many expect. Consider that Bankia requires €19bn, while three other very troubled cajas need around €30bn (Banco de Valecia, Novagalicia and Catalunya Caixa) meaning half the money could already be eaten up, leaving only €50bn for the rest of the huge banking sector.

This compares to around €140bn in doubtful loans, and a total €400bn exposure to the bust real estate and construction sector. Doubtful loans to this sector total around €80bn currently, but we expect house prices to fall by a further 35%, broadly meaning that the number of doubtful loans could easily double. On top of this we have further losses on mortgage loans as well as losses on other corporate debt and a decrease in the value of Spanish debt held by banks. So huge number of issues - putting a clear figure on it is difficult due to the difference between tier one capital and 'loss provisions' (tier two capital). But even if this €50bn is given in tier one capital and stretched to increase provisions its hard to see that it will be enough given the huge exposure to mortgages and the bust sectors, especially at a time when growth is falling further and unemployment continues to rise.

Finland and Ireland - flies in the ointment?
If the EFSF is used (which looks likely) the Finnish government is obliged to ask for 'collateral' as it did with Greece - the noises coming out of Finland suggest it will, especially given its objection to 'small' countries bailing out 'larger' ones. Ireland has also suggested that if Spain is able to avoid fiscal conditions on its bank bailout then it could request similar treatment (i.e. a loosening of 'austerity').

Open Europe take:
The Finland issue will get messy, as it did in Greece. It will add another complex layer to negotiations, while politically it will help the (True) Finns who are already launching a campaign against further bailouts. It could also lead to legal challenges - as we pointed out with Greece, it could trigger 'negative pledge' clauses on Spanish bonds given that they essentially become subordinated to Finland's claim on Spain. Not guaranteed, but a legal grey area which adds to the confusion.

As for Ireland, they have a fairly strong case here. Ultimately, their fiscal troubles stemmed from bailing out their banks, something Spain is now able to dodge thanks to external help. Ireland already feels that it is paying a huge price for protecting the European banking system - this will only add to this ill feeling. Given Ireland's perceived 'success' in Germany some flexibility may be forthcoming but we doubt enough to assuage Irish anger.

Impact on the UK?
The IMF will only play a 'monitoring' role, meaning the UK will not be liable for the money provided to Spain. However, given the links between the UK and Spanish banking systems it is imperative that the problems in the Spanish financial sector are finally dealt with - whether that will happen this time around is yet to be seen but given the points above it is not off to a great start.

Impact on the eurozone - Open Europe concluding remarks:
Markets responded positively to rumours of external aid for Spain on Friday afternoon, but, given the points above, a huge amount of uncertainty remains which will keep markets jittery and increase pressure on the eurozone. That is far from needed given the uncertainty surrounding the Greek elections. Given the ongoing assessment of the actual needs of Spanish banks the rescue will now enter a state of limbo as attention turns back to Greece, in the meantime Spain is likely to find it difficult to access the market (since this is broadly an admission it cannot raise any substantial funds itself).

Questions will also arise over the strength of the eurozone bailout funds - Spain guarantees around 12% of them, surely its guarantees are now worthless or would do more harm than good. Additionally, now that one of the larger countries has asked for support pressure will intensify on Italy (particularly with the falling support for the technocratic government and the slow pace of reform).

Spain races against time

Things are looking sticky in Spain.

Firstly, the Spanish government announced a bail out of Bankia to the tune of €19bn in addition to the €4.5bn already put in - and is currently looking at the least painful way of getting cash to the bank. The plan is still up in the air. Yesterday there was talk about swopping government bonds for shares in the bank (Bankia could then use the bonds as collateral to get more cash from the ECB). This made a lot of people nervous, not least the Germans, who already worry that the link between states and ECB funding, via banks, is getting a bit too strong. Today's talk has instead focused on issuing bonds from Spain's specific bank bailout fund, FROB, to raise the cash Bankia needs.

Secondly, Catalonia - Spain’s wealthiest region - has asked the central government for financial assistance to repay its €13bn debt; bad news for the central government's debt and deficit. Thirdly, the the spread between Spain and Germany’s ten-year bonds reached its highest level since the introduction of the euro, with Spanish ten year bonds currently at around 6.4%.

There are a huge number of issues on the table here, but these events highlight three things that we pointed to in our April 3 briefing on Spain:

• Despite Spanish PM Rajoy's remarks to the contrary, it looks increasingly as if Spain is slowly realising that it may not be able to afford to directly fund Bankia or other banks that run out of cash. And the numbers could well go up. This, in combination with talks and leaks over recent days that European money will be needed to backstop the Spanish banking system (Rajoy is very keen on more from the ECB), indicates that Spain is now moving ever closer to bank bailout via the EFSF.

• A huge battle looms over the finances and economic autonomy of Spanish regions, that remain a massive liability for the central government's attempt to cut its debt and deficits.

• Spain is racing against the clock. Naturally it will take time for the structural reforms that Spain is pursuing to have an impact - time that markets just won't give it at the moment.

Instead, it looks as though that time may soon have to be bought by eurozone taxpayers.

Spanish banks...Mañana, Mañana...?

The Spanish government held a press conference this afternoon finally laying out its plans for dealing with its significantly troubled banking sector. As usual Spanish Prime Minister Mariano Rajoy dodged the limelight and left the unenviable task of presenting the proposals to his Deputy, Soraya Sáenz de Santamaría, and Finance Minister Luis de Guindos – despite this being par for the course with the new government we still can’t help but feel that it fails to inspire confidence.

That fact aside, the plan did include a few concrete details on how Spain plans to deal with the Spanish banking sector, below we outline the key points and give our take:

·         Two independent auditors will carry out an evaluation of all the real estate assets held by Spanish banks – the Deputy PM termed this “an exercise in transparency”.

Open Europe take: We have been calling for this for some time, so believe it is a positive step. However, we have seen that similar tests have been fudged in the eurozone and Spain before, so it is very much wait and see. Taking an adverse scenario and ensuring these assets are written down to their real values is key – if they start posting falls in the future it will reignite the uncertainty surrounding the banking sector. The Spanish government also failed to mention that, at least according to the Spanish press, de Guindos was going to be asked to hire independent auditors by his eurozone counterparts at the meeting of eurozone finance ministers next week.

·         By the end of 2012, provisions to cover against losses on real estate loans considered as ‘non problematic’ will have to increase from 7% to 30%.

Open Europe take: This seems far too low. Given comparisons to Ireland we expect real estate prices could fall by another 35% in Spain. Additionally, this move seems to be skipping a step – Spanish banks already have €136bn in ‘doubtful’ loans against only €54bn in provisions, surely provisions against these very risky assets should be increased first or at least in tandem.

·         In absolute terms, this means an increase of around €30bn.

Open Europe take: Again, far too little. We predict that Spanish banks would need to at least double their provisions, taking them up to around €100bn. Similar estimates abound, with RBS calling for an additional €100bn and Roubini Global Economics suggesting it could go as high as €250bn over the next few years. Meeting the Basel III capital requirements will put further strain on the sector.

·         Banks will be allowed to get money from the FROB, but will have to pay 10% interest on it – Spanish Economy Minister Luis de Guindos stressed that this money cannot therefore be seen as state aid. Suggested maximum use of public funds would be €15bn. Heavy use of ‘contingent convertible capital’.

Open Europe take: This seems to be poorly thought out and based on an ideological reaction. Clearly the government is keen to avoid being seen to bail out banks, and rightly so. However, the banks tapping these funds will be those locked out of the interbank funding market (due to high rates), punishing them with 10% interest will make this recourse worthless. Any use of public funds should come with strong conditions but better to focus on letting some banks fail and be wound down in an orderly fashion, while forcing those that take funds to produce ‘living wills’ and give the state equity warrants. Contingent convertible capital can be useful but does not fundamentally solve the problems facing the banks, again it simply delays dealing with the problems and kicks in as a last resort safety mechanism – will do little if provisions are shown to be woefully small or valuations far too high.

·         Spanish banks will be obliged to transfer real estate assets into ad hoc societies tasked to sell them on the markets – i.e. the ‘bad bank’ that dare not speak its name.

Open Europe take: Potentially a large burden for the state, but given the breadth and depth of the problems across the sector some form of ‘bad bank’ scheme looked hard to avoid. The key here will be transferring the assets at realistic values so that they are sellable or can be written off. The Irish experience with NAMA makes this point clear – a bad bank stuck with uncertain assets can be a huge burden to the state. Furthermore, it could also distort the recovery of the sector as a whole, if the overvalued assets pile up on state books it will be hard for the remaining market to adjust – something which is necessary if the Spanish economy is to rebalance and recover.

The market response to the proposals has been lukewarm at best with Spanish borrowing costs rising slightly and the shares of many Spanish banks falling sharply.

There are some positive steps in the proposals and we will reserve full judgement until the complete package is announced and the stress tests have been detailed, however, it again seems to be a step short of what is needed. The key to tackling these banking sector problems is doing so decisively and in one swoop, rather than pushing the problems to tomorrow. Incremental adjustments increase uncertainty and expose the state to a longer and more volatile burden than needed - given the size of the Spanish economy, that is something which the eurozone cannot afford now or in the future. 

The beginning of the end game in Greece?

At some point you have to wonder if Greece just enjoys the limelight…

This weekend’s election was expected to be relatively predictable with the largest parties forming a coalition and eventually adhering to the latest EU/IMF bailout package. Most eyes were on the French Presidential election and its impact on the Franco-German axis. Unfortunately, as we predicted, there were still a few surprises in store in Greece. Here’s the (almost) final result:

New Democracy – (18.86%) 108 seats

SYRIZA – (16.77%) 52 seats

Pasok – (13.18%) 41 seats

Independent Greeks – (10.6%) 33 seats

KKE (Communist party) – (8.48%) 26 seats

Golden Dawn (far-right) – (6.97%) 21 seats

Democratic Left – (6.1%) 19 seats

The biggest surprise is clearly the huge rise in SYRIZA’s share of the vote and the drastic fall in Pasok’s share.

In our post in the run up to the elections we laid out three scenarios: a stable ND-Pasok coalition, an unstable coalition leading to new elections where ND win a majority and an unstable coalition which falls leading to a cycle of elections where no-one can win a clear mandate. Those three scenarios clearly still hold, but the probabilities have definitely changed. Previously, the likelihood ran in order, however, now the second and third scenarios are looking increasingly probable.

ND and Pasok only hold 149 seats, short of the 151 majority they need. The Democratic Left has ruled out joining a three-way coalition. This makes new elections (probably in June) essentially inevitable as there is no stable coalition to be formed.

However, given the showing in the elections it is hard to imagine ND, or any party, gaining a clear majority. Given the strength of the anti-austerity feeling in Greece it is unlikely that these results would be a one-off. The anti-austerity parties only look likely to gain ground in subsequent elections, making a stable coalition less likely. This analysis suggests that a cycle of elections looks increasingly probable in Greece.

What does all this mean for the eurozone?

More uncertainty, that’s for sure. Germany and the EU have already both come out to reiterate the need for Greece to maintain its commitment to the latest bailout packages, stress that keeping Greece in the euro requires strong participation from both sides (rather ominous if you ask us).

Unfortunately, this looks unlikely, even if by some miracle ND and Pasok manage to form a workable coalition at some point. ND leader Antonis Samaras has already come out saying that he will “modify the memorandum [of understanding]” with Greece’s creditors to focus on growth. This can probably be seen as the start of his next election campaign but will still send shivers down the spines of German politicians.

A renegotiation of some form looks on the cards and will not be well received. Samaras would still be the EU’s preference given his history of strong rhetoric but then still signing up to the bailout programme. The alternatives are not appealing from eurozone leaders’ perspective: either there is a cycle of elections leaving no government in place to implement the reforms or the anti-austerity feeling grows so strong that a SYRIZA led government of some form comes to power, signalling the end of the bailout programme for good.

There is a confluence of factors here which increases the prospect of a Greek exit from the eurozone. The broader feeling in Greece although still in favour of the euro is shifting strongly against austerity – how this tension will play out is unclear but the usual fall-back of broad public support for the eurozone looks shakier than it has ever been.

Since the last round of poisonous bailout negotiations the eurozone and financial markets have been preparing for a Greek exit, if not publicly than definitely behind the scenes. The stance against any renegotiation and flexibility on reforms has hardened from eurozone leaders. Furthermore, Greece is approaching a primary surplus, the point where an exit and a full default look slightly more attractive as the country could (at least in theory) survive without access to financial markets or direct support.

Greece’s future will not be decided in the next few days but the coming weeks and months could well settle its place in the eurozone once and for all. This election may not provide many answers, as we expected, but it could mark the beginning of the end game in Greece.

S&P compounds a bad week for Spain all round

It's been a tough week in Madrid and Barcelona with the economic problems rivalling even the footballing troubles for coverage.

At the start of the month we highlighted the significant risks still in play in the Spanish banking sector and some of the wider policy issues in Spain. Echoing the conclusions in our briefing, over the past few weeks the calls for Spain to address these issues have grown louder while markets have grown increasingly jittery.

However, the pressure has noticeably picked up this week. The obvious example is last night’s decision by S&P to downgrade Spain to BBB+. This hasn’t had a huge impact on the markets, given that it was mostly expected and priced in, but the reasons behind the downgrade are nonetheless interesting and align with some similar points which we highlighted in our briefing:

- The on-going problems in the banking sector mean that a new injection of public money may well be needed at some point – which would significantly worsen Spanish debt sustainability and the ability of the government to meet deficit targets
- The continuing growth challenges and competitiveness problems in Spain
- Although encouraging the structural reforms will take some time before they boost economic growth
- In the short term these structural reforms could actually increase unemployment (supported by today’s figures which show unemployment increase by 1.5% over the past three months) 

S&P also went on to criticise the wider handling of the crisis at the eurozone level and the continued failure of eurozone leaders to address the true cause of the crisis (something which we’ve mentioned countless times throughout the crisis).

On top of this move, the IMF also warned earlier this week that some of the smaller Spanish banks could need public money to boost their capital ratios and/or provisions against losses on exposure to the bust real estate and construction sectors. In our report we suggested that, given deteriorating economic conditions and falling house prices, the banking sector as a whole may need to double its provisions against souring loans. Goldman Sachs recently made a similar estimate, suggesting that a further €58bn may be needed on top of the current provisions of €54bn.

If this does happen, the question remains over whether it will be done with Spanish or European funds. Despite the clear limits on the amounts available to the Spanish government the stigma attached to asking for even a precautionary loan from the EFSF/ESM will make it a last resort. Not to mention the fact that, since it has to go through the state, any loan would increase the debt levels further.

Separately, in a move that doesn't inspire confidence the Spanish Foreign Minister Jose Manuel Garcia-Margallo today warned that the country faced a crisis of “massive proportions” and that “if it goes badly for us, it’ll go badly for others too”. Even worse, in a warning to Germany, he compared the eurozone to the Titanic, stating that when it went down the 1st class passengers went down with it before issuing the usual rallying cry for more growth. 

Despite increasing concerns a bailout for Spain is, as we have said before, not yet a foregone conclusion. But the government needs to begin making headway convincing the market of its commitment to cleaning up the banking sector and promoting growth, but obviously both are easier said than done. With election season seemingly upon us in Europe it could be a long few months in Spain which could make or break the eurozone.

The ECB loads up on PIIGS exposure

Reuters MacroScope blog covers some of our updated figures on the exposure of the ECB to the struggling peripheral countries. Following the ECB’s Long Term Refinancing Operations (LTRO) the ECB’s exposure to these countries has increased significantly, without their situations showing any sign of improvement – in fact many of them are now in a worse position.

Last year we showed that the ECB exposure to the PIIGS totalled €444bn. Just a year later this has increased by a whopping 106%, to €918bn. The exposures are detailed below:

Total exposure - €917.61bn 

Exposure through lending programmes - €703.61bn 

Greece - €73.4bn
Ireland - €85.07bn 
Italy - €270bn 
Portugal - €47.54bn 
Spain - €227.6bn 

Exposure through the Securities Markets Programme - €214bn 

This gives the ECB a massive leverage ratio 38.4:1. This in itself is not the issue, more concerning is the fact that a third of the ECB’s balance sheet now resides in the PIIGS.

On top of this, while the ECB’s exposure has been rising the quality of collateral supporting this exposure has been deteriorating quickly. There are a few factors underlying this:

 - The value of the huge amount of PIIGS sovereign bonds which PIIGS banks hold has fallen while the default risk involved with them has risen quickly.
- The sovereign guarantee which backs up many of these banks (both explicit and implicit) has also become less solid as the states’ finances worsen and public outrage against bank bailouts increases.
- The risks and losses held on the balance sheets of these banks is yet to be fully acknowledged or fully realised in many cases. (For example, see our recent briefing on the massive problems in Spanish banks relating to their exposure to the bust real estate and construction sectors).
- The ECB has widened its collateral scope allowing even more opaque and harder to value collateral to be used to bank up its unlimited liquidity provision. 

That is to name but a few of the issues in play (we'll have a fuller discussion of the implications of this next week).

The real question which should be asked in all this is: how has the eurozone crisis continued to worsen despite the ECB more than doubling the money it has poured into these states?

Patently, the current approach to the eurozone crisis has failed. Even the ECB’s massive interventions only bought a short amount of time (and a lot less than many may have expected). The eurozone continues to fiddle at the edges of the crisis. All the talk of ECB lending, eurozone firewalls, IMF resources and austerity programmes fails to accept some of the fundamental flaws which underpin this crisis.

The eurozone needs to accept that there are a few structural flaws underpinning the eurozone crisis and move to correct them, not least: an endemic lack of competitiveness in the peripheral states, a structural bias towards low growth, a massively undercapitalised banking sector, mismatched monetary policy and a currency which remains grossly overvalued for many of its members. Until these issues are tackled, with both widespread political and economic will even further sprays of ECB liquidity will do little more than buy time, while further raising the cost of the potential break-up.

Update

The figures on exposure through lending programmes were obtained from the websites of the national central banks of:

Greece
Ireland
Italy
Portugal
Spain

The Spanish sovereign-banking loop

A heavy going blog post for a Friday afternoon, but you can digest it over the weekend (lucky you!). One of the key themes we highlighted in our recent briefing, comment pieces and general coverage on Spain is the importance of the sovereign banking loop.

The idea here is that the fate of the Spanish banks and the Spanish state are becoming increasingly intertwined. The two are always connected: if a state goes down normally its banks will too, while if banks fail the state often has to bail them out to support itself (or at least that is the prevailing logic).

As the eurozone crisis has progressed numerous states (PIIGS) have had significant trouble funding themselves (selling debt). In many cases the only people willing to buy a sovereign’s debt has been their domestic banks. In turn, a situation arises where banks pile more and more risky debt while the state becomes entirely reliant on them for financing. Far from ideal.

The unlimited ECB lending and the LTRO has only exacerbated this cycle and there is a strong correlation between increased reliance on ECB funding and the sovereign-bank loop – Spanish bank borrowing from the ECB jumped by €75bn in March, an increase of 50%.

An editorial in the FT today argues that the Spanish government has done well to avoid recapitalising its banks at cost to taxpayers, especially since many of the banks could fail without bringing down the state. This is undoubtedly a positive thing - taxpayers should be kept out of the equation as much as possible as taxpayer-backed bailouts invariably create the wrong incentives (i.e. moral hazard).

But for intellectual honesty, it's also vital to account for all sides of the sovereign-banking loop.

As we noted in our recent briefing the primary aim should be to force banks to recapitalise themselves and ensure they have sufficient provisions against bad loans. However, if they get into significant trouble the chance of a self-fulfilling bond run on Spain increases significantly as the domestic banks stop buying bonds. This could push the whole country into a bailout, which the eurozone could barely (if at all) afford.

This situation is a clear side effect of the failed policies taken on by the eurozone and the ECB, which we have long argued against – failing to tackle the underlying back solvency problems, loading them up with cheap liquidity and encouraging them to fund struggling states was always going to lead us here. Unfortunately, given the state of affairs now, suggesting that Spanish banks are too small to bring down the state misses how dependent the state is on cash from domestic banks.

A Spanish banking crisis and the ensuing bond run on Spain are very real threats to the eurozone. The Spanish government needs to push banks to increase provisions against losses and a thorough stress testing would go some way to highlighting just how much they need. We are loathe to suggest any cost be transferred to taxpayers, but realistically (given the eurozone's bail out policy) this option may what the Spanish government and eurozone leaders have to go for in the end, either through the FROB (Spanish bailout fund) or the ESM (eurozone bailout fund). If so, it's of course extremely important that any funds should come with strong conditionality including giving the government preferential shares and equity warrants as well as forcing banks to produce ‘living wills’.

But whatever happens, eurozone leaders must stop seeing a bail out as an end in itself. If it comes to that, unlike the ongoing ECB and bailout operations, any injection of funds should be part of a full assessment of the viability of the institution with fair consideration given to the prospect of winding those down that don't have a sound financial footing for the long term. Banks must simply be allowed to fail. Ultimately, purging the bad practices and poor management which helped fuel the boom and bust in Spain will be vital for the long term health of the banking sector and the economy.

The link between the health of the Spanish banks and the health of the Spanish state remains very strong - unfortunately neither is looking in a good position right now.

Spanish fears stoked by genuine concerns over banks and regional government spending

We've got a piece over in City AM today looking at the reasons behind the increased financial market jitters over the state of the Spanish economy. Despite the usual EU protestations that Spanish fundamentals are sound, there are definite areas of concern present in the Spanish economy - not least, as always, the banking sector. That's not to say a bailout is assured but simply that more needs to be done to ensure the stability of the Spanish economy and convince the markets that Spain is on the path to a full recovery.

See below for the full piece and see here for our full briefing on Spain:

WITH a sense of inevitability the spotlight has landed on Spain. Though the headlines proclaimed that the Eurozone crisis has returned with a vengeance, the truth is it never left. Spain is not Greece, but, many of the market fears surrounding the economy are still both well-founded and expected. There are three major causes of concern: the exposure of Spanish banks, regional governments’ fiscal profligacy and a risk that structural reforms won’t reap benefits soon enough.

The vulnerable banking sector remains the likely trigger for any future downturn in Spain. One in five of the loans by Spanish banks to the bust real estate and construction sectors is seen as “doubtful”, i.e. at serious risk of never being repaid. Against some €136bn (£112bn) in potentially toxic loans, Spanish banks hold only €50bn in loss provisions. And things are likely to get worse. House prices have declined quickly over the past six months and may fall by another 35 per cent, if there is to be the same level of adjustment as seen in Ireland.

This is troubling, firstly, because Spain cannot afford to bail out its banks. And, secondly, because Spanish banks have been the main recent buyers of Spanish sovereign debt. If these banks don’t have the cash to buy Spanish debt, then who will? This massively increases the prospect of a self-fulfilling bond run on Spain and the chances of an ill-fated Spanish bailout.

Not to be outdone, the regions look to be harbingering plenty of problems of their own. The regions have seen the amount of unpaid debt on their books rise by €10bn (38 per cent) since the start of the crisis. The total in unpaid bills now tops €36bn. Yet again, this cost is likely to be transferred to the central government, which can ill afford it, and risks the country missing its deficit target, further fuelling market jitters. The regions are also expected to contribute 44 per cent of the planned deficit reduction this year. But with the budget still hot off the press, the largest and wealthiest regions are already rejecting Madrid’s ordered spending cuts.

The good news is that the new Partido Popular government is pushing through some much needed structural reforms. Unfortunately, it will take time for the benefits to be felt, and in the short term they are likely to increase already skyhigh unemployment while doing little to boost lagging demand.

Spain remains a serious and diverse economy, with relatively good administration and infrastructure – talk of a full bailout programme is premature. The most likely outcome is some sort of aid for the banking sector – probably with the help of the European stability mechanism. As much as we hate seeing risk being transferred to taxpayers, it might be better for Spain to swallow this bitter pill now and ask for aid for its banks, than risk it dragging the whole economy – and the euro – over the edge.

Not so bullish now? The short term prospects for Spain inside the eurozone

In a new briefing, Open Europe assesses the state of the Spanish economy in light of recent budget proposals, announced by the Spanish government in full today. Spain is not the “next Greece” - it remains a serious and diverse economy, with relatively good administration and infrastructure. However, the increasing exposure of its banks to potentially toxic loans, the difficulty in curbing Spanish regions' spending and the risk of reforms not taking effect quickly enough, all raise serious questions as to whether the Spanish economy will make it through without some sort of external help.

Key Points

• Given its size, the fate of the Spanish economy will also largely decide the fate of the euro. €80bn of €396bn (1/5) in loans that Spanish banks have made to the bust construction and real estate sectors are considered ‘doubtful’ and potentially toxic, meaning at serious risk of default, with the banks only holding €50bn in reserves to cover potential losses. Already dropping, house prices could potentially fall another 35%, meaning that Spanish banks will almost certainly face hefty losses as more households default on their mortgages.
• In such a scenario, the Spanish state is unlikely to be able to afford to recapitalise its banks, meaning that the eurozone’s permanent bailout fund (the ESM) would have to step in, shifting the cost to eurozone taxpayers.
• As domestic banks are currently the main buyers of Spanish government debt, this could also lead to major funding problems for Spain. The chances of a self-fulfilling bond run on Spanish debt would increase massively in this scenario, threatening to push the whole country into a full bailout.
• Containing spending in the Spanish regions is also key to Spain rebalancing its books. The level of unpaid debt on the balance sheets of local and regional governments has risen by €10bn (38%) since the start of the crisis (now topping €36bn). This will likely be paid off by the central government, increasing the country’s debt and deficit.
• Spain’s various reforms, particularly to the labour market, are welcome, but are themselves not enough to stop a bond run, as it will take time before they bite. The country’s long- term unemployment has now reached 9% of the economically active population, and youth unemployment reached 50.5% last month. This is threatening the long term productivity of the economy and whether Spanish society can sustain this level is unknown.

A Spanish bailout is far from a forgone conclusion, but more work needs to be done to avoid one. Open Europe recommends:

• Spanish banks double their provisions against souring loans and commit to thorough stress tests.
• Strengthen labour market reforms, particularly to relieve the welfare burden on state finances, including: end wage and pension indexation to inflation, reduce size and duration of benefits, limit collective bargaining, reduce redundancy costs and improve the business climate.

However, these reforms will only stand the test of time if they enjoy political buy-in across Spanish society and are seen as democratically legitimate, rather than being imposed from outside.

To read the report in full, please click here,
http://www.openeurope.org.uk/Content/Documents/Pdfs/Spain2012.pdf

UK banks and the ECB – part 2

We'll get back with a take on today's €529 bn of loans by the ECB to 800 banks, via the so-called LTRO, soon.

But first, something different. Remember, we've long been critical of the ECB's backhanded QE, which has created a range of zombie banks in weaker euro economies (reliant on ECB funding to survive). See here, here, here, here, here and countless other examples of when we're looked at this issue. So it's odd that we're now literally taking the 'oh it's not so bad' view in a discussion about whether the ECB is 'bailing out' banks. Well, at least UK banks.

This after the Left Foot Forward blog claimed, and then re-stated, that "the EU" is bailing out UK banks, after Loyd's (now confirmed) and possibly RBS (unconfirmed) accessed funding from the LTRO 2 (see here for background on this issue). We still do not see how this constitutes a 'bailout'. Again, these UK banks are merely saving cash through avoiding an extra exchange rate charge and borrowing at cheaper rates, rather than relying on more expensive (but still available) sources of funding. While the money will only be used to fund their European operations. This just isn't a 'bailout' in any sense of the word.

The Left Foot Forward provides a politically interesting interpretation, but, we believe, also misunderstands some crucial points:

- If it amounts to a bailout, it's a contender for the smallest one in history. €15bn (if that's the final amount) is equivalent to a tiny amount of the UK's banking sector, the assets of which amount to numerous times the size of UK GDP (around £1.5 trn). €15bn is hardly the difference between life or death for UK banks and surely not enough to signal the need for a complete change in approach.

- Lower collateral requirements are not directly tied in with the LTRO, as the Left Foot Forward blog suggests. It's a separate policy (just announced at the same time), but was not in place for the first LTRO, so to claim this is the whole motivation for the LTRO is a misnomer. It may allow UK banks to use assets which may not be accepted elsewhere, but is that enough for it to be considered a bailout? The only instance where this association would work is if UK banks had already used all other collateral worthy assets to gain liquidity - this simply is not the case. In fact the main choice for UK banks is whether the reduced cost is enough to offset the negative 'stigma' of using the LTRO.

On the wider point about QE style interventions, the blog is also confused. Does it want a UK LTRO or lower collateral requirements or both and would this be instead of QE or on top of it?

- Here we would say that the BoE already did its (more direct) version of the LTRO with the Special Liquidity Scheme and its ‘Quantitative Easing’ (QE) programme. It's still overshooting its inflation target by some way, throwing more liquidity into the system seems impractical and risky.

- Furthermore, money in the system has increased steadily in both Europe and the UK but lending has not, which is a problem. But increasing liquidity will not solve this. As results from January show, lending in the eurozone still fell despite the December LTRO. It fell by less than the previous month but still not a resounding victory for the theory that the LTRO is a clear cure to all the lending problems in the wider economy.

We could go round and round discussing the intricacies of the problems facing banks in Europe but ultimately there are endemic structural problems which cannot be solved by simply throwing more liquidity at the problem - in either the UK or the Eurozone.

Many questions around the second Greek bailout remain unanswered

We finally have an agreement on the second Greek bailout…in principle. It only took eight months. If you’re of the belief that a disorderly Greek default would have triggered Armageddon, the deal that was agreed (as ever ‘agreed’ is used loosely) by Euro finance ministers in the early hours of this morning is broadly good news.

Unfortunately, it is once again hopelessly optimistic and contains numerous gaps and unanswered questions which could still bring down the whole deal. This is nowhere outlined better than the damning leaked debt sustainability analysis (see here for full doc).

Below we outline a few key issues (not exhaustive by any means, there are many more) and give our take on how they could play out.

Greater losses for private sector bondholders: Reports suggest the Greek government was sent back to the negotiating table with bondholders at least four times during last night’s meeting. Nominal write downs for bond holders now top 53.5% (or around 74% net present value). The leaked Greek debt sustainability analysis (DSA) assumes a participation rate of 95%.

Open Europe take: 95%, really? We weren’t convinced the previous threshold of 90% with a lower write down would be reached and that was while potential ECB participation was still on the table. Although this target may have been agreed with the lead negotiators for the private sector, it is far from a cohesive group, diminishing the value of the agreement. It will be interesting to see how bondholders respond to the plan but we think that hold outs could well be more than 5%.

Greek ‘prior actions’: The deal includes a list of requirements which Greece must meet in the next week to get final approval for the bailout. These include: passing a supplementary budget with €3.3bn in cuts this year, cuts to minimum wage, increase labour market flexibility and reforms opening up numerous professions to greater competition.

Open Europe take: The now infamous €325m in cuts still needs to be specified. The huge adjustments to labour markets and protected professions mark a cultural shift in Greece – pushing these through will not be painless and could result in further riots.

Fundamental tensions in objectives of the programme: The DSA notes that the prospect achieving a return to competitiveness while also reducing debt is very small – the massive austerity could induce a further recession.

Open Europe take: As we have noted all along the assumption that Greece can impose massive levels of austerity and then return to growth in the next two years is a big leap and almost inherently contradictory. We’d also note that the cuts in expenditure in Greece are larger than have been attempted anywhere in recent memory (successful or failed). Likely to be substantial slippages in the austerity programme while the growth programme remains almost non-existent, essentially closing the book on Greek debt sustainability.

Further favourable treatment for the ECB: ECB and national central banks avoid taking losses on their holdings of Greek bonds but promise to redistribute ‘profits’ from these holdings so that they can be used in Greece.

Open Europe take: See our previous post for a full discussion of this issue. Markets still don’t seem too worried by suddenly being subordinated by central banks in Europe – they should be. This raises questions of the basic premise that all bonds are treated the same, based on who issued them not who holds them. As we’ve noted before, the whole concept of ‘profits’ is misleading, while any distribution would happen anyway – this is not a commitment from central banks but a further fiscal commitment by the eurozone (should really be included in total bailout funding).

Greece may not be able to return to the market even after three years: The DSA points out that any new debt issue will essentially be junior to existing debt, hampering the chances of Greece issuing new debt in 2014/2015.

Open Europe take: This point isn’t too clear but given that the eurozone, IMF and ECB will own such a larger percentage of Greek debt in 2014 any new private sector debt will be massively subordinated and at risk of taking losses if anything goes wrong with the Greek programme. Additionally after the restructuring the remaining private sector debt will be governed under English law and will have the EFSF sweetener – further subordinating any new debt issued to the market. Why would anyone want to purchase Greek debt in this situation (especially given the other concerns above)?

EFSF funding requirements: The EFSF will have to raise €70.5bn ahead of the bond swap – €30bn in sweeteners for the private sector, €5.5bn to pay off interest and €35bn to provide Greek banks with assets to use to gain liquidity from the ECB.

Open Europe take: We’ve already questioned whether raising these funds so quickly can be done and whether the approval from national parliaments will be forthcoming. Even if it is the €35bn is said to fall outside of the €130bn meaning it is expected to be returned swiftly – given the uncertainty over how long banks will need these assets (as long as Greece as declared as in selective default by the rating agencies) this may be a generous assumption.

There is also no talk of the money to recapitalise banks. This is a risky strategy given that Greek banks’ main source of capital (government bonds) will have just been wiped out significantly. The needs were previously specified at €23bn, although reports now suggest they could top €50bn. It’s not clear where this money will come from or when it will be raised. The bond restructuring will be like dancing through a minefield for Greek banks.

We’re still trawling through the responses, analysis and documents to come out of the meeting – meaning there are likely to be plenty more questions and uncertainties to come.

The one thing that is clear is that even if this bailout is ‘successful’, it will set Greece up for a decade of painful austerity and low growth leading to social unrest, while the eurozone will have to provide on-going transfers to help it keep its head above water.

Sorry to be killjoys but as Dutch Finance Minister Jan Kees de Jager put it, the deal isn’t “something to cheer about”.

Another exposure which could sink Greek banks?

An interesting but niche issue has come to our attention recently in relation to the on-going troubles in Greece. The 'Baltic Dry Index' (a measure of global shipping demand/prices) has fallen for a month straight to record lows. When this index falls it suggests that there is trouble in the shipping industry, raising questions over the stability of shipping firms. As it turns out many of these firms have secured their financing from Greek and other European banks – meaning if they start defaulting on their loans these banks could take losses. This raise further questions over the bank recapitalisation plans and whether such contingencies have been thought of in the second Greek bailout (which sets aside €20bn for Greek banks).

As a recent NYT article noted:

“Basil Karatzas, the chief executive of Karatzas Marine Advisors, a ship brokerage and finance advisory firm in Manhattan, estimated that European banks hold about $500 billion in shipping loans on their books and face nearly $100 billion in losses to restructure them.”

Furthermore, not only does global demand seem to be faltering (although the index may not be the best judge of this), there is also a massive over supply of ships – due to orders put in during the boom period in 2008 which are only just being completed now (the equivalent of 22.7% of the cargo shipping fleet is due be produced this year alone). This suggest a combination of supply and demand issues which means this could become a lasting problem and will not just be tackled with a boost in growth in Asia.

Data on exposure to shipping loans is scarce, but in 2010 Greek banks had a portfolio of $16bn just on Greek owned shipping. Other European banks had about a $50bn exposure. Of this the 4 largest UK banks had $16bn and 10 German banks had $18bn.

The volatility of the index should be kept in mind but it’s an interesting fresh angle on the problems in Europe. If things keep going badly in the shipping sector, which it seems almost certain they will, some banks could face an increase in the level of non-performing loans on their books. Given that capital buffers already seem to be spread pretty thin this could cause problems. Of course this could take time to have an impact, if it does at all, but worth keeping an eye on.