New York – Ever heard of the European Monetary Authority? Hold that thought.
For more than a decade now, banks in Europe have been free-riding on sovereign credit support, a fact that has attracted more than a few foreign investors. With the political devolution now underway in Rome, however, Eurobanks have begun to trade again on their intrinsic credit. In an important new paper from The Institute for New Economic Thinking, Professor Ed Kane of Boston College states the problem succinctly using ratings from our friends at Kamakura:
“[T]he recovery of European megabanks from the 2008-09 crisis has been incomplete. Creditors of Europe’s giant banks still seem to be relying on implicit guarantees. In particular, credit spreads on the bonds of these banks appear to be relatively insensitive to the level of the issuer’s longer-term probabilities of default. Coupled with the high pairwise correlation that KRIS default probabilities show between major US and European banks, this finding suggests that creditors do not expect the EU’s bail-in requirements to play much of a role in resolving megabank insolvencies during the next crisis.”
Even before the 2008 financial crisis, global regulators were moving on a set of proposals that eventually became known as Basel III. When the discussions began in earnest, the ask from the US side was that Europe do something about non-performing loans in the banking system. The Europeans, for their part, insisted that housing assets – particularly evil mortgage servicing rights or MSRs -- be consigned to the bad bucket along with other supposed intangibles such as net loss carry forwards. Below is our discussion last week with Brian Sullivan of CNBC.
The final Basel III document focused mostly on liquidity and capital, but neatly skirts the issue of credit quality. The US banking system is particularly strong when it comes to recognizing and liquidating defaulted loans, in large part because US banks generate strong profits and are able to resolve bad debts in reasonable periods. In Europe, however, banks are less profitable and debtors tend to have the upper hand. There are no bankruptcy courts in Europe. As a result, EU banks have tended to extended forbearance to defaulted obligors, particularly those with access to political influence.
There are three pillars of the Basel bank supervision approach: (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. Most of these pillars are observed in the omission in Europe. Capital requirements, notably illustrated by the cases of Deutsche Bank AG (DB) and Montepaschi Group, are largely a fiction. Supervision is fragmented among the 28 EU member states. And market discipline in the EU is largely prohibited via explicit legal limits on short-selling and official “guidance” to banks, rating agencies and large investment firms.
Since 2010 when the Basel III rules were announced, there has been a steady but painfully slow recognition by the Europeans that something needs to be done about credit quality and therefore bank solvency. In March of 2018, the European Central Bank announced that bank loans that become non-performing after January 1, 2018 must be adequately reserved, but left aside the issue of non-performing loans recognized prior to this year.
The seemingly absurd ECB announcement about reserving loans that go bad from January 1st of this year is part of a larger political dance. The ECB is trying to perform damage control among and between member states that still control bank supervision at the national level while at the same time paying lip service to capital and Basel III. There is no mechanism for supervising EU banks on a unified basis, nor any agreement on loss sharing or even a retail deposit insurance safety net. And the biggest obstacle to moving forward with these initiatives is the enormous public antipathy toward banks.
In Italy the government has managed to move significant amounts of bad loans off the books via securitizations with government guarantees on the senior tranches. “Huge volumes of NPLs (€37bn in 2016 and over €47bn in 2017, according to consultancy Deloitte, have been sold by banks, often to specialist American hedge funds like Cerberus Capital Management or Fortress Investment,” the Economist reports. The European Commission has agreed that these securitizations of bad loans do not constitute state aid “as the guarantee will be priced at market levels.”
The latest official figure on bank NPLs from the Bank of Italy is 11 percent of total loans, an enormous figure but better than the mid-teens number reported in 2016. Banca Monte dei Paschi, for example, reported 14 percent NPLs at the end of Q1 ’18. By comparison, a bit over 1 percent of loans held by US banks are currently marked as past due. The peak of US NPLs was 5.5. percent in Q4 2009, when the US banking industry charged off $60 billion in bad credits in a single quarter. Such an act of financial housecleaning is impossible in Europe.
Investors may gain some comfort from the upbeat views of consultancies such as Deloitte, who noted in a 2016 report on the early efforts to securitize Italian NPLs: “While these reforms may not be the all-encompassing panacea that is needed, any moves to cleanse bank balance sheets of distressed debt has to be welcomed.” But as we’ve told any number of investors over the past few years, there is no practical way to estimate loss resolution timelines or recoveries on non-performing commercial assets in Europe.
Of course, auditors like Deloitte and the other major firms must operate in the world of stated financials and prudential regulation as it exists in Europe today. Because of issues with both the definitions behind and presentation of financial disclosure in Europe, particularly when it comes to credit, we still view the official numbers on NPLs in Italy and the rest of southern Europe as being deliberately understated.
In Italy, for example, prudent investors proceed on the assumption that total NPLs are probably twice the official levels. Italian banks, owing to political and financial realities, are not prepared to bring their level of asset quality and disclosure to the levels of their US counterparts. When the new ECB rules on NPLs go into effect in 2021, it will be interesting to see if Italy and other Southern European nations actually comply.
If you are doing business with a bank anywhere in Europe, the reality is that a foreign investor or ratings analyst or banker or regulator will never know if a given bank is sound or not. There is no culture of disclosure in the EU when it comes to banks. There is no SEC Edgar system for public banks, no FDIC and FFIEC for all US depositories. The disclosure by Monte dei Paschi of its bad loans is contained in a single table.
Click here to see the Bank Holding Company Performance Report for Deutsche Bank Trust Corp, the top-tier unit of DB in the US that was recently red flagged by the Fed for operational issues. There is no similar public source of information in Europe for DB or any other depository. Instead in the EU there is a private network of data dissemination based upon 28 national accounting rules and national regulatory regimes. Your only indicators of risk are prices for a bank’s debt and equity and the relevant sovereign benchmarks.
Since as Professor Kane observes many EU banks have been trading like quasi sovereign credits, recent market volatility begs the question as to both bond spreads and equity market valuations. Of note, the guarantee pricing mechanism for the Italian NPL securitizations depends upon the pricing for credit default swaps (CDS) for a basket of Italian issuers as well as the credit support of the Italian government. With the rise of the explicitly anti-euro coalition in Rome, the practical value of that Italian state guarantee certainly comes into question.
One aspect of this situation that deserves attention from investors is the precarious nature of funding in the EU banking system. In the Euro zone, German banks make the system go by carrying over €900 billion euros of float in the form of unsettled credits for the rest of the system. This means that German banks enable payments by banks in Italy, Spain, Portugal, and Greece, notes former Fed counsel and researcher Walker Todd.
Todd explains that the US Federal Reserve System avoids the buildup of large inter-district debit and credit balances by settling accounts systemwide on a weekly basis. “In the old days, that is why $10,000 notes existed -- to facilitate the clearings,” Todd avers. For whatever reason, when the euro was established in 1997, no provision for periodic intercountry clearing and settlement was included. This has led inexorably over time to the strongest member country extending a great deal of unintended credit to the rest of the EU system, especially the weakest countries' banking systems.
As the M5S/Lega coalition engages with the other EU member states, they would do well to remember that the Germans ultimately are financing short-term borrowings via the ECB. Of note for investors in Italian banks, German chancellor Angela Merkel rejects any debt forgiveness schemes for Italy – one of the early demands from the M5S/Legal government that was apparently dropped – at least for now.
Merkel stated flatly that solidarity among euro area members should not lead to "a debt union” – a concept that would spell political suicide for Merkel and her coalition. Yet it is some measure of the dire situation in Europe that the German leader leaves open the possibility of a bailout for Italy. French President Emmanuel Macron advocates the creation of a specific budget for the euro area, with the appointment of a finance minister, and the transformation of the European Stability Mechanism (ESM). ) into a European Monetary Fund (EMF). Merkel apparently agrees.
"If the entire eurozone is in danger, the EMF must be able to provide long-term credit to help countries, Merkel said last week. “Such credits could be spread over 30 years and granted on the condition that the beneficiaries undertake structural reforms."
The reality in Europe is that structural reforms never occur in large member states, only in the subordinate states such as Ireland, Greece and Spain. Italy, as Europe’s largest debtor state, lacks the political will to get its banks and fiscal situation in order. Thus Merkel seems to be preparing the way for a bailout for Italy if for no other reason than to protect German banks. Think of it as a larger version of the Greek project.
The M5S/Lega coalition has explicitly threatened sovereign debt default, an explicit act of extortion focused on Germany and Angela Merkel. Is an EU bailout bullish for Italian banks? Maybe in the near term. But ultimately we think that Italy’s fiscal disarray will destroy the EU and lead to an Italian exit and currency devaluation with the reintroduction of the lira. In the event, banks in Italy and throughout the euro area will be severely impacted.