Europe
Stress Testing Europe
July 02, 2010

By Elga Bartsch | London

ECB's unlimited liquidity unable to break the circuit: The ECB's unlimited liquidity provision has created some perverse incentives for banks and governments. The sovereign debt crisis, which caused fresh concerns about European banks, underscores that a circuit-breaker is needed. In our view, this circuit-breaker is the recapitalisation and, where needed, restructuring of the banking system.

Bank stress-test might be the circuit-breaker: Detailed bank-by-bank results of a pan-European stress-test are an important step in the right direction.  Some hurdles still remain though. These include a different cyclical backdrop, regulatory uncertainty and bank levies. In addition, we look at the reasons for the relatively sluggish take-up of existing bank rescue funds and argue that these are unlikely to be removed. 

Tapping into the EFSF for funding if needed: Similar to the Greek Financial Stability Fund, part of the EFSF loan could be used for bank recapitalisation.  However, the government would need to meet the strict conditionality attached to EFSF loans, including a fiscal austerity programme and further structural reforms.  Before such lending could happen, the EFSF would need to become operational and its guarantors would need to approve the activation unanimously.  Hence, the hurdles for using the EFSF remain rather high, we think.

The lure of the ECB's unlimited liquidity: In a recent note, we argued that the ECB's unlimited liquidity provision in response to the financial crisis created some perverse incentives for banks and governments (see The Lure of Liquidity, Joachim Fels and Elga Bartsch, June 16, 2010).

We stressed that a circuit-breaker was urgently needed: In our view, this circuit-breaker is a restructuring and recapitalisation of the banking system. This week, the imminent roll-off of the ECB's one-year tender, which provided an unprecedented €442 billion of fresh liquidity to the banking system a year ago, has been spooking equity markets.  While we feel that these concerns are overdone, we also believe that ECB liquidity does not get to the root of the problem. 

Could the stress-test be the circuit-breaker? If the US experience is anything to go by, the publication of the results of the pan-European stress-test on a country-by-country and bank-by-bank basis could mark a turning point. The publication of the results of a stress-test of the 19 largest US banks and their subsequent recapitalisation was widely perceived by investors to be a ‘game changer' (see Large-Cap Banks: Stress-Test: Today's Cushion, Tomorrow's Buyback? Betsy Graseck et al., May 8, 2009).  Other factors, such as a trough in the ISM, the start of QE and steep yield curves, also helped though. Nonetheless, the agreement to publish the detailed results of a harmonised pan-European banks stress-test in the second half of July is an important step into the right direction, in our opinion.

Several key differences remain though: Rather than coinciding with the early stages of the recovery, sentiment indicators seem to have peaked globally.  Searching for an explanation for the recent drop in US Treasury yields and echoing some concerns about the sustainability of the US recovery, markets have even started to debate the danger of a double-dip.  In addition, there is regulatory uncertainty about Basel III, with the BIS Committee not making detailed suggestions until September, and with implementation unlikely before 2012.  Add to that the prospect of specific bank levies and it seems clear that some hurdles still remain even after the stress-test.  One of the key achievements of the stress-test though could be to provide key information on bank balance sheets on a comparable basis in one place.

We discuss the macroeconomic aspects of the bank stress-test below: Our comments should be seen in conjunction with the in-depth sector-specific analysis provided by Morgan Stanley credit strategists and sector specialists.

Risks around the test and how it is communicated: It is vital, we believe, that the results are credible and transparent.  Our colleagues in Morgan Stanley's banks teams on the equity and the credit side will especially focus on how the macroeconomic scenarios translate into bank-specific estimates of impaired assets and/or non-performing loans.  In the current environment, investors are not only concerned about the economy, unemployment, equity markets and house prices.  They are also concerned about the repercussions of the sovereign debt crisis.  While we deem it unlikely that the stress-test would include a scenario of a euro area country restructuring its debt, a sell-off scenario in peripheral bond markets, modelled on a widening of intra-euro area spreads, seems feasible to us.  Alternatively, banks could simply disclose their holdings of government bonds by country and let markets derive their own estimates.  Another question surrounds the capital definition that the results will be based on and whether the hurdle is set at a convincing level. Our banks analyst, Huw van Steenis, points out that in the US the minimum hurdle was 50% higher than in the last pan-European stress-test (6% for Tier 1 capital ratio rather than 4%, see European Banks: Stress-Tests and Bank Funding - An Update, Huw van Steenis et al., June 18, 2010).  In recent days, press reports suggested that the new stress-tests will be done on a higher Tier 1 capital ratio of 6%.  Our banks team notes that such a move to make the tests more credible would be a positive.

A key issue is whether policy action would follow: A key element of the US stress-test was that those institutions that did not have sufficient capital buffers were forced to raise capital in the market and/or accept an injection of public capital.  To put it simply, the US approach was to inject all institutions with a preventive dose of extra capital - think of it as an inoculation - and to reverse the burden of proof such that those institutions who were able to show that they didn't need the extra capital could pay it back.  Thus far, Europe has seen relatively slow take-up of the various bank rescue funds set up by different governments.  In our view, there are several reasons for the sluggish take-up.  While the stress-test will likely increase the pressure to recapitalise, it will not remove all of these obstacles.

First, problems seem to be brewing in the state-owned banking sector.  Here, financial markets are not able to force a fast resolution as they were for stock market-listed banks.  It is only in the interbank market that signs of stress show as many of these banks reportedly find it increasingly difficult to access funding markets.  Courtesy of the ECB's unlimited supply of liquidity to all European banks, this has not been perceived to be a pressing problem though.  Due to the lack of transparency in the interbank market, there is also no external pressure on policy makers.

Second, in many cases, the state-owned banks that are perceived by investors to be troubled are owned by regional government bodies. These regional bodies are often reluctant to own up to the solvency issues their local financial institutions are facing.  In many cases, federal governments have found it hard to overcome political resistance from within the political establishment of their respective countries, even in cases where it seemed clear that federal funds were needed.

Third, under European state aid rules, all capital injections into financial institutions need to be approved by the European Commission.  The Commission watches over any public money going into businesses to make sure that the provision of funds does not constitute a competitive distortion.  Typically, the requirements of the European Commission refer to the fees charged by governments for a guarantee or for a capital injection.  However, in some cases the Commission has made rather draconian demands about restructuring the financial institution in question.  These demands could potentially be a deterrent for those who still (believe that they) have the choice to delay. 

Fourth, under US regulation a rights issue can be executed in a very short span of time.  In Europe, existing shareholders need to be given a period to contemplate whether they would like to participate in the rights issue. If existing shareholders are diluted by more than 10%, this period can be up to three months.  Thus, the regulatory framework also slows down the process of private capital raising compared with the US.

Fifth, notwithstanding the bold policy action taken following the US stress-test, credit continued to contract in the US.  This deleveraging process has not even started yet in the euro area, suggesting that the positive impact of the European stress-test might lag the US one (see European Credit Strategy, Financial System Letter, Regional Comparisons, Andrew Sheets et al, March 12, 2010).

The publication of the European bank stress-test is a move in the right direction, in our view.  We also welcome the reported broadening of the panel from largest 25 banks (most of which have already stated that they will pass) to the largest 100-120 institutions.  With regulators (and banks themselves) readying themselves for public scrutiny, the proverbial ‘genie' is out of the bottle now.  The political process behind this decision also shows that the institutional competition between different European governments is working. Initially, it was Spain that pushed for a release of the stress-test results at the EU Summit.  Then Italy and France indicated that they would also consider publishing a more complete set of results at the national level, causing Germany to agree to the publication of more detailed results eventually. 

In our view, the ECB's unlimited liquidity provision in response to the financial crisis also created some perverse incentives for both banks and governments.  The full-on carry trade put on by banks when a one-year tender was made available a year ago probably created new risks as banks loaded up on government bonds, notably peripheral government bonds, and funded these purchases with the cheap funding available from the ECB.  Hence, with the benefit of hindsight, we believe that the ECB quantitative easing strategy, which worked through its lending operations, has likely contributed to a postponement of any solution to the banks' solvency issues (see again The Lure of Liquidity).

Worse, ECB liquidity has helped to set in motion a vicious circle between banks and bonds, in our view.  Over the last few weeks, the sovereign debt crisis has sparked a new banking crisis in the euro area, forcing the ECB to inject fresh liquidity into the banking system via additional long-term refi operations. More importantly, though, the ECB had to ‘bite the bullet' and start buying government bonds in mid-May. Meanwhile, governments resorted to additional austerity measures and set up a European Financial Stabilisation Facility (EFSF), which will act as a lender of last resort to euro area governments (see Enter the EFSF, Elga Bartsch and Daniele Antonucci, June 7, 2010). Given the weakness of many euro area governments and the sheer size of the fiscal and financial sector holes, the lure of liquidity simply proved too strong, it seems. 

To pave the way for a sustainable economic recovery, a circuit-breaker is needed.  In our opinion, two policy issues need to be addressed: On the one hand, financial stability needs to be restored by cleaning up bank balance sheets and recapitalising those institutions that are thinly capitalised.  On the other hand, public finances need to be put back on an even keel by mapping out the exit from the ballooning budget deficits.  Tackling just one aspect - financial stability or sovereign solidity - still leaves the door open to negative spillovers, given that the banking system and public finances are so closely intertwined.  It seems to us that the US has made good progress in fixing its financial sector, while the euro area has mainly addressed the fiscal aspect. Until both aspects are addressed, the recovery remains a half-way house. 

Clients and colleagues have asked us whether the EFSF could become a ‘Euro-TARP' following the €10 billion within the Greek bail-out package (totalling €110 billion) that is earmarked for a Financial Stabilisation Fund.  Our understanding is that, in principle, the EFSF could help to fund the recapitalisation of the banking system if a sovereign in the euro area were to find itself unable to raise the necessary funds in the market.  However, it is unlikely, in our view, that the EFSF will take direct exposure to the banking sector. In fact, the Greek loan agreement explicitly stresses that it does not involve direct exposure to the Greek banking system.  Under the framework agreement signed on June 7 by all euro area finance ministers, the EFSF would lend to the government in question.  This means the government would need to meet the strict conditionality attached to such loans, including a fiscal austerity programme and further structural reforms. 

The hurdles for using the EFSF are quite high, we think: In addition, the requirements of Article 122(2) of the EU Treaty would need to be met, i.e., the country would need to find itself in financial difficulties caused by exceptional circumstances beyond the control of the member state.  A lax interpretation of this clause could open potentially the route for a law case being brought at the European Court of Justice against loans being made by the EFSF.  Furthermore, the request would need to be accepted by a unanimous decision by all guarantors of the EFSF (i.e., the 16 euro-zone member states except Greece).  Last but not least, at the time of writing, the EFSF has not yet been approved by 90% of its shareholders, which is needed for it to become operational.

The Greek Financial Stability Fund

Sovereign downgrades, increasing loan impairment, and the deteriorating economic outlook have undermined confidence in the Greek banking sector. The sharp slowdown in economic activity is expected to reflect negatively on banks' profitability, with the potential of eroding capital bases. To safeguard the soundness of the financial sector, the FSF will be set up to provide banks with a safety net in the event additional capital resources cannot be found from the private sector. The government will set up the FSF by June 30, 2010, as a structural benchmark under the SBA agreement with the IMF.

The new entity would provide capital support to the banks through the purchase of preference shares.  Such instruments will be convertible in ordinary shares and will have the benefit of strengthening the core capital base of banks. In this way, participation of the FSF in the shareholder base of the banks will be limited, in the first instance. By providing investors with a credibly stronger equity base, it will facilitate banks to re-access capital markets for financing and thus limit recourse to Eurosystem facilities.

After an appropriate amount of time, if the preference shares have not been repaid, the FSF would require a restructuring plan. This would be consistent with the EU legislation requirements for state aid and fair competition. The restructuring plan will be devised by the FSF specifically for the credit institution, in consultation with the Bank of Greece. Should the financial targets set under the restructuring plan not be complied with, the FSF will have the power to convert the preference shares into ordinary shares. The conversion price will be determined by applying the principles of EU legislation on state aid and fair competition.

The FSF will manage its participations in the banks with a view to selling all its holdings in a limited timeframe and to maximize sale proceeds. The FSF will have a duration limited to seven years to de-couple it from the political cycle. It will make use of its shareholder rights to steer the board of the credit institution in a direction which would maximize its market value. Any shares remaining in the FSF at the time it ceases its activities will be transferred to the MoF.

The MoF will fund adequately the FSF from the proceeds of the IMF-eurozone credit disbursement to Greece. The amount of funds destined for the FSF will be €10 billion, which would accommodate expected losses under a stress-test scenario. The resources made available by the eurozone and the IMF under the programme are more than sufficient to cover this amount.

The FSF will be independent, transparent and accountable. Appointees by the Bank of Greece, the Governor of the Bank of Greece, and the Ministry of Finance will sit on the board, while the appointees by the ECB and the EC will have the right to participate in board meetings as observers. The power of the Governor of the Bank of Greece to nominate its director is expected to give it some distance from domestic treasury operations. However, the FSF will report regularly to the Greek parliament, the EC, the ECB, and the IMF staff.

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