Standard Life Investments

Published Article

Institutional Investor - Halfway House


The initial euphoria over the comprehensive package aimed at putting a floor under the downward spiralling debt crisis across Europe has faded rapidly. The cornerstones of the package – ring-fencing Greece, recapitalising the banks, leveraging the European Financial Stability Facility and forcing Italy to take more comprehensive austerity measures – look good at face value but lack sufficient detail. The unexpected decision by Greece to call a referendum on the bail-out package has added further uncertainty and the hard-nosed response from France and Germany arguably threatens the cohesiveness of the Euro. Putting those concerns to one side, we have concluded that the plan does not go far enough for bank bond investors and leaves them stuck in the halfway house. Ultimately, what Europe must resolve is the far more fundamental issue of the interconnectedness of banks and their sovereigns. This is key for both a lasting resolution of the crisis and the overall health of the various European economies.

Looking at the detail of the package, European authorities hope to stabilize its banking system in two important respects. Firstly, banks need more capital, around €106bn as estimated by the European Banking Authority. This had been widely flagged in the run up to the announcement but was still towards the lower end of the €75-420bn range which had been discussed at earlier points in the third quarter. Secondly, the agreement stressed the additional need to ensure the term funding of banks by providing guarantees on bank liabilities. This latter policy tool was less expected and while welcomed may be more challenging to implement. More crucially, it can be seen, arguably, as further cementing the problematic link between governments and banks.

The initial reaction to the need to raise capital has seen a similar response from many European banks. With around nine months to meet the new capital threshold, the majority of banks think the target will be met through a combination of retained earnings, lower dividend payments and “balance sheet optimisation”. Where a shortfall persists, banks must use private sources of capital before turning to their national government or the European Financial Stability Facility (EFSF). As positive as it is that banks are being steered away from using state funds, the possibility of debt-for-equity swaps has negative implications for subordinated debt holders even before bail-in legislation is introduced across Europe.

Furthermore, the decision to meet the new capital hurdle rate through the phrase “balance sheet optimisation” should fill the authorities with a degree of concern. European banks need to reduce the size of the funding gap between bank deposits and loan books. There are two ways of doing this – grow deposits and/or reduce assets. With deposit growth anaemic, the most likely option is to reduce assets, either, or both, non-core lines of business and their loan books.

Credit creation makes economies tick but the manner in which banks are likely to address the capital shortfall risks the clock stopping altogether - and with it the prospect of economic growth which is what is ultimately required to bring a full and definitive resolution to the crisis.

Fortunately, the authorities appear to be alive to this issue which they have sought to address with the promise of guaranteed funding of liabilities. The first step of this process has already been established with the European Central Bank agreeing to set up two new long term refinancing operations in November, for 12 months, and December, for 13 months, as well as guaranteeing full allotment in three-month repos until July 2012. This is relatively straightforward and should ensure no major bank suffers from a short term liquidity problem. The second step, providing guarantees on term funding, is aimed at providing banks with an alternative solution to shrinking their balance sheets. Yet, as simple as it sounds, the practicalities are more complex.

It is unclear so far how this guarantee will be structured. The European Investment Bank has firmly denied that it will be the guarantor although it has said that it is prepared to provide technical expertise to the discussions with the European authorities on developing funding solutions for the banking sector. It is unclear whether the EFSF has the capacity to provide this guarantee. Although this would most likely be an unfunded liability for the fund and therefore European governments, there is a risk that markets and rating agencies view this as a contingent liability with potentially negative consequences for the AAA-rating of the EFSF.

A further method of providing a guarantee is directly from a bank’s host nation. However, while this may help German or French banks, it is unlikely to be a solution to those banks in the peripheral nations. Indeed, the statement that a guarantee mechanism for term bank funding is being examined has a hint of déjà vu about it and brings us full circle to September 2008 when Ireland became the first nation to guarantee bank liabilities.

Prior to the surprise announcement from Greece, European governments had finally devised the architecture of a more comprehensive plan to deal with the sovereign crisis which has engulfed the Eurozone over the last 18 months. There may be positive news to come if the EU can entice external investors such as China or Japan to support the plan. The immediate consequence of the announcement thus reduced the probability of a negative tail risk event such as the break up of the Euro – now decisions in the Greek political system are the key trigger for such an event.

However, longer term, there are issues that remain unaddressed such as the extent of the impact on European economies from shrinking bank balance sheets. Most crucially, and the core structural problem that needs to be resolved, is that banks continue to own significant amounts of their host government’s debt. The announced solutions may only further link them to their governments through funding guarantees. This interconnectedness continues to threaten banks’ ability to fund balance sheets, extend credit and in extremis, confidence in banks’ capitalisation in times of distress and thus ultimately the prospects for economic growth. Until this link is broken, it is too early to proclaim that there has been a final resolution to the Eurozone crisis.

Andrew Fraser, Investment Director, Standard Life Investments

First Published in Institutional Investor on 09th November 2011