Friday, 04 February 2011 17:59

Is Another Banking Crisis Inevitable?

Today, Bloomberg reports that Goldman Sachs Turns Bullish on Europe Banks as Debt Risk Eases.The report goes on to state:

The U.S. bank that makes the most revenue from trading advised investors to take an “overweight” position on banks, raising its previous “neutral” recommendation, according to a group of equity strategists led Peter Oppenheimer. Investors should pay for the trade by lowering holdings of consumer shares, he wrote.

“For financials the narrowing of sovereign spreads in peripheral eurozone, which our economists expect to continue, is a clear positive,” London-based Oppenheimer wrote in the report dated Feb. 3. “Banks are one of the least expensive sectors in the market and the trade-off between their growth prospects and earnings in the next few years looks especially attractive.”

Unfortunately, the risks of this particular trade were not articulated, and I feel that the risks are material. Far be it for me to disagree with the "U.S. bank that makes the most revenue from trading", but they have been wrong before - many times before. Reference Is It Now Common Knowledge That Goldman’s Investment Advice Sucks??? or Did Reggie Middleton, a Blogger at BoomBustBlog, Best Wall Streets Best of the Best? for more on this topic.

Attention subscribers: A new subscription document is ready for download File Icon The Inevitability of Another Bank Crisis

So where is the risk?

The impact of the Asset Securitization cum Sovereign Debt Crisis to bank balance sheets should become the market and media focus. The full cost of cleaning up the balance sheets of financial institutions particularly against the backdrop of adverse macro shocks emulating from sovereign defaults is not fully known. Structural weaknesses in sovereign balance sheets could easily spill over to the financial system due to the fact that most banks are stuffed to the gills with sovereign debt – highly leveraged, and marked as risk free assets at par. This can have broad, adverse consequences for growth in the medium term.

Since banks balance sheets are still highly vulnerable to external shocks with precedent setting levels of NPAs, particularly from an economic perspective (as opposed to an accounting perspective which is what is commonly followed) a sovereign crisis [read as defaults/restructurings] could cause equity wiping holes in banks’ balance sheets. Overall, NPA’s to bank loans (world average) have increased to 7.6% in 2010 from 5.9% in 2005. Greece’s NPA-to-loans has increased to 9.0% from 6.3%, Hungary to 7.8% from 2.3%, Spain to 5.5% from 0.8%, Romania to 17.5% from 2.6%, Central and Eastern Europe to 11.5% from 4.5% and US to 10.3% from 0.8%, in the corresponding period. Elevated NPA levels which already pose a threat to banks loan losses coupled with sovereign risks losses could result in massive write-downs on investments in banks trading (AFS – available for sale) and banking books (HTM – hold to maturity). A common shenanigan used both in Europe and the states is to shift the most problem assets from the AFS category where they are more rigorously marked to market to the HTM category where they are considered kosher because they are allegedly to be held to maturity. The issue is, if there is a default or restructuring, they are worth materially less - no matter how long they are supposedly held for. This valuation his is multiplied several time since it is banks business models to leverage up on these securities to increase yield.

Banks NPAs to total loans

Source: IMF, Boombust research and analytics

Euro banks remain weak as compared to their US counterparts

Health of European banks is weaker when compared to US banks. European banks are highly leveraged compared to their US counterparts (11.1x versus 4.1x) and are undercapitalized with core capital ratio of 6.5x vs. 8.5x. Also, the profitability of European banks is lower with net interest margin of 1.2% compared with 3.3%. However, non-performing loans-to-total loans for European banks are slightly better off when compared to US with NPL/loans at 4.9% vs. 5.6%. Nonetheless, considering the backdrop of high exposure to sovereign debt in Euro peripheral countries, we could see substantial write-downs for Euro banks AFS and HTM portfolio, which would more than offsets the relative strength of loan portfolio.

EURO Stress Test Rebuffed, Again

The OECD working paper “The EU stress test and sovereign debt exposures” by Adrian Blundell-Wignall and Patrick Slovik rebuffs the EU stress test, as we have several times in the past. The argument in the white paper echoes BoomBustBlog view that accounting policies allows banks and financial institutions to mask their true economic health. An asset that has declined in value leads to economic loss irrespective of its classification as held-to-maturity or held-for-trading, but accounting policies allow banks to mark down only their trading portfolio to the current market value while leaving a large chunk of held-to-maturity at book value even if said asset loses 50% in value that would take years to recover, or the bank could be presented with the very distinct possibility that there may be no recovery of said value loss. The former event (of recovering back to book value) would mask the true economic picture at a given snap shot of time while the latter (no recovery) is more of time shifting distortion wherein current profits are inflated for future losses.

Coming back to the EU stress test, the paper contends that by focusing only on the trading book exposures, the EU stress test gave a rosy picture of banks true health.

•     Sovereign bond haircuts were applied only on the trading book holdings with implicit assumption that bonds held to maturity will receive 100 cents in the euro. This assumption severely understates the banks losses as 83% of banks investment portfolio is in banking books in form of held-to-maturity assets while only 17% of assets are held in trading portfolio. In case of sovereign default, the distinction between the banking book and the trading book simply disappears. By considering only a smaller component of banks investment books, EU stress tests have severely undermined the estimated write-downs on banks books and have given rosy picture about banks true health. The logic of said methodology is that with the EU/ECB/ EFSF SPV (basically, a giant new European CDO) backing, no sovereign state will be allowed to default.

•     Second, and more importantly, the market is not prepared to give a zero probability to debt restructurings beyond the period of the stress test and/or the period after which the role of the EFSF SPV comes to an end.

o   The assumption of no default over 2010-2012 appears reasonable given that the EFSF is made up of a €720bn lending facility (€220bn from the IMF; €60bn from the EU; and the SPV can build exposures for 3 years to the limit of €440bn for the 16 Euro area countries) which provides a guarantee of funding for any countries facing financing pressures, certainly for the next 3 years.

o   However, the concerns in the market beyond 2012 are: the longer-run fiscal sustainability problem; and the difficulty of achieving structural adjustments in labor and pension markets and ability to achieve a sustainable growth in a period of budget restraint. The fear is that this will not be resolved by the time the support packages run out, and hence the probability of restructuring may not be put at zero by portfolio managers. Angela Merkel has recently announced her willingness to spearhead several common nation reforms to put the EU block of nations on heterogeneous footing in regards to regulation, debt management etc. This will go a long way to solving the problem at hand, but will also put significant strain on several of the weaker nations, again exacerbating the probability for restructuring to bring said nations in line with their stronger counterparts.

Impact of bank’s banking books on haircuts

EU banking book sovereign exposures are about five times larger than trading book. The table below gives sovereign exposure of major European countries for both trading and banking book. The EU trading book has €335bn of exposure while banking book has €1.7t exposure towards sovereign defaults. EU stress test estimated total write-down’s of €26bn as it only considered banks trading portfolio. This equated to implied haircut of 7.9% on trading portfolio with losses equating to 2.4% of Tier 1 capital. However, if the same haircuts (7.9% weighted average haircut) are applied to banking book then the loss would amount to €153bn equating to 13.8% of Tier 1 capital.

We have also presented an alternative scenario since we believe that EU stress test had failed not only to include banks HTM books but also the loss estimates were highly optimistic, as has much of the economic and financial forecasting that has come from the EU. It is highly recommended that readers review Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse! for a detailed view of a long pattern of unrealistically optimistic forecasting. Here's and example...




In an alternative scenario, we have assumed weighted average haircut of 10% (exposure, haircut assumptions and writedowns for individual countries are presented in detail in the tables below) and have applied writedowns on both banking and trading books with the results available in the subscription document File Icon The Inevitability of Another Bank Crisis? Individual and more explicit haircut calculations are available for the following nations for professional and institutional subscribers:

Interested readers can follow me on twitter and review our latest European opinion and analysis. I will be lecturing on this "realistic" style of analysis as the special guest speaker at the ING Real Estate Valuation seminar in Amsterdam. See

Last modified on Friday, 04 February 2011 19:34