Just when you thought it was safe to be a bank again...
BANKS in France, Italy and Spain performed better than most in the rich world during the turmoil of 2008-09. They had smaller investment-banking operations, lower leverage, more stable funding and fewer losses. But if Lehman Brothers' collapse was unthinkable, they now face the unimaginable: fears of a sovereign-debt crisis in the euro zone. These continue to mount despite the bail-out package for Greece announced on May 2nd. European bank shares dropped by 8.5% over the course of May 4th and 5th, with Iberian firms hit hardest. Portuguese and Spanish bond yields and credit-default-swap spreads are heading up, indicating that investors reckon the odds of government defaults, though small, are rising (see chart).
The direct danger to banks from small euro-zone countries going bust is manageable. The Bank for International Settlements (BIS) reckons European banks' exposure to Greece and Portugal was €298 billion ($429 billion) at the end of last year, including government and private-sector counterparties. That is less than the size of Lehman's balance-sheet, and in any case few banks have the kind of intertwined relationships with neighbouring countries as they did with the Wall Street firm. A loss of, say, a third of that amount would not be life-threatening. The top 22 European banks had Tier-1 capital of €726 billion at the end of 2009, according to CreditSights, a research firm, and made profits before tax and bad-debt charges of €184 billion last year. That is a massive safety buffer.
Furthermore the BIS data include foreign banks' subsidiaries in Greece. History suggests that, in extremis, foreign parents can ringfence local subsidiaries and decline to give them any more cash, as happened in Argentina in 2001-03. That leaves them on the hook for just their shares in the subsidiary and any loans they have made to it, not for its entire balance-sheet. Ringfencing a subsidiary in a fellow European Union country would be hard. But in a default scenario there is a real chance that parent companies might avoid taking the full hit, pushing part of it instead onto local creditors. This might help explain why France's banks, deemed to be heavily exposed to Greece by the BIS, seem relatively unruffled by this week's events.
It is not Portugal or Greece that really scares investors, however, but the spectre of a crisis in much bigger Spain, to which Europe's banks had some €590 billion-odd of exposure at the end of last year. Yet only the harshest of judges would say Spain is insolvent. Its public finances are no worse than those of many other rich countries, and the big banks can handle the modest sell-off in government bonds seen so far. Santander, for example, holds €27 billion of Spanish and Portuguese government paper, against Tier-1 capital of €58 billion and profits before tax and bad-debt charges of €22 billion in 2009. That is a different scale of problem from 2008, when bad assets were multiples of many banks' capital and earnings had collapsed.
Could the private sector bring down Spain's banks, in the form of dodgy property-market exposures? The central bank says loans to property developers and construction firms stood at €445 billion at the end of 2009 (of which €166 billion are judged as suspect). Against this the banks had €42 billion of specific reserves and a further €16 billion of general reserves, suggesting they could absorb a loss rate of 13%. By comparison America's government "stress tests", conducted a year ago, assumed a loss of 9-12% on commercial-property loans. On top of these reserves, Spain's banks had €226 billion of equity and €57 billion of profits before taxes and bad-debt charges in 2009. Admittedly both the dodgy assets and the loss-absorbing buffers are not spread evenly. Spain's unlisted savings banks, or cajas, are typically in a much worse condition than the big listed firms. Still, as a system, Spain does have a big cushion to absorb losses.
Sovereign defaults in Greece or Portugal would not in themselves bring down Europe's banks. A crisis in Spain would, but the evidence that its government and banking system are bust is weak. Yet the lesson of the crisis in 2008-09 is that to survive, banks need to show not just that they are solvent, taking into account ongoing profits, but also that they can fund themselves if wholesale borrowing-markets gum up. Meeting this second test may be tougher. For all but the most geographically diversified banks, the sovereign-bond yield of their home country puts a floor under their own borrowing costs. If those rates rise, banks face a squeeze on their profits. In the worst case they cannot get any funds at sane prices.
Both Spanish and Portuguese banks lend more than they gather in deposits, creating a gap that capital markets fill. The listed banks are at pains to point out that the maturity profile of these debts is sensible, with, for example, only 5% or so of the total needing to be rolled over each six months for Spain's banking system. The big two Spanish banks, Santander and BBVA, have more or less covered their refinancing needs for 2010. Portugal's banks are typically covered, too, if you also include unencumbered assets (like government bonds) they can use to borrow from central banks. In the medium term Iberian banks hope savings rates will rise, allowing them to gather more deposits.
The risk now is less about the maturity of medium- and longer-term debt, more that other counterparties such as depositors and lenders in interbank markets lose confidence and begin to pull out. There is already evidence of outsider banks discriminating between different euro-zone governments: Bank of China's latest annual report pointedly noted problems in southern Europe. Even if a country's overall funding profile is tolerable, deposits may start to flow from small banks to bigger, safer ones that can afford to pay high interest rates. This is already happening in Spain and will put intense pressure on the savings banks, which account for about half of the banking system. Spanish politicians agreed on May 5th to speed up mergers between wobbly cajas.
What, then, is needed to prevent jitters becoming a crisis? One set of tools is now all too familiar: a rapid government resolution of smaller, troubled banks, and access to liquidity for all banks, both through more relaxed rules at the European Central Bank (protecting banks against further downgrades of their collateral) and bigger and longer debt-guarantee schemes from governments to help banks roll over debts. But if governments themselves are deemed dodgy, the only solution may be to reassure creditors that there is a backstop in the form of European or IMF help for other countries in trouble.
SOURCE: The Economist
