Tests Will Stress Financing Ties That Bind Banks to Countries: Euro Credit

Europe’s bank stress tests will reveal how reliant nations are on their domestic lenders for funds, while detailing how much government support the finance industry needs to stay solvent.

“Banks are only as strong as the sovereign,” said Michael Riddell, a London-based fund manager at M&G Investments, which oversees about $323 billion. “A sovereign sells off as the risk of restructuring rises, then the banks sell off and they need more capital, ratings fall, funding costs rise -- and you’re in a vicious circle.”

Euro-region banks are the biggest creditors to debt-ridden nations such as Greece and Italy, tying their fortunes to the sovereigns. That’s why, when government bond yields climbed to records across the euro region this week they dragged a gauge of bank risk to the highest in six months.

Investors and traders will be looking out for the most detailed breakdown of banks’ government debt holdings yet when the European Banking Authority publishes the results of its stress tests after markets close today. Authorities are seeking to buttress investor confidence by showing banks have enough capital to withstand the shocks of the region’s crisis.

“Greater transparency is always welcome,” said David Owen, chief European financial economist at Jefferies International Ltd. in London. “Unless, of course, in the midst of a crisis it sheds more light on potential problems and allows participants to focus on the weakest links.”

‘Explosive’

European Central Bank executive committee member Lorenzo Bini Smaghi said on July 11 the link between lenders and sovereigns is “explosive.”

Yields on 10-year Italian bonds rose to as high as 6.02 percent this week and Spanish yields climbed to 6.31 percent as the crisis spread. The Markit iTraxx Financial Index of credit- default swap contracts used to insure bank and insurance company debt jumped to as high as 186 basis points today, after climbing to 203 on July 12, the highest since January, according to JPMorgan Chase & Co.

The stress tests will show the size and maturities of 91 banks’ sovereign bond holdings, the regional split of loans and lenders’ capital strength. To pass, lenders will need to maintain a core Tier 1 capital ratio -- a kind of buffer against losses -- of more than 5 percent in certain stressed scenarios.

Shortcomings

What the tests won’t take into account is the impact of a sovereign default, which Hank Calenti, London-based head of bank credit research at Societe Generale (GLE) SA, said undermines the process.

“The real weakness in the European banking system is going untested,” he said.

Instead the stress tests consider the impact of a four-tier ratings downgrade of the weakest governments, such as Moody’s Investors Service inflicted on Portugal this month.

Moody’s slashed Portugal’s rating four levels to a junk grade of Ba2 from Baa1 on July 5, citing the risk the country will need a second bailout. The New York-based firm cut Ireland a grade to Ba1 for the same reason a week later.

Fitch Ratings downgraded Greece by three levels this week to the lowest rating for any country, following the two biggest ratings companies and saying a default is a “real possibility.” Moody’s said June 17 it was reviewing Italy’s Aa2 ratings for a possible downgrade and a week later did the same to 16 of the nation’s banks, including UniCredit SpA (UCG) and Intesa Sanpaolo SpA (ISP), the two biggest.

‘Mutual Dependency’

“Europe’s banks are funding Europe’s governments, which are keeping the banks afloat,” said Bill Blain, strategist at Newedge Group, a London-based brokerage established in 2008. “The stress test results will reinforce just how vulnerable that mutual dependency has become.”

Credit traders reckon there’s an 87 percent chance of Greece defaulting in the next five years, a more than 60 percent chance of Ireland or Portugal failing to pay their bills and a 23 percent probability of the same happening to Italy, according to CMA prices for credit-default swaps.

That throws the credibility of the stress tests further into doubt, because to be believed they should force banks to hold enough capital to survive an event “with a five to 10 percent probability of happening,” Ian Smillie, a London-based Royal Bank of Scotland Group Plc analyst, said in a note. Basing the tests on current government bond prices “would lead to widescale recapitalization” of banks, he said.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Domestic banks are keeping euro-region nations afloat by buying large amounts of their short-term bill sales, such as those issued by Italy and Greece this week, according to Peter Chatwell, a fixed-income strategist at Credit Agricole SA. (ACA)

“The issuer might default,” London-based Chatwell said. “But as a bank that’s intrinsically tied to your home sovereign, you’re going to have a different perception of that risk than a multinational.”

To contact the reporter on this story: John Glover in London at johnglover@bloomberg.net

To contact the editor responsible for this story: Paul Armstrong at Parmstrong10@bloomberg.net

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