Slovenia, the first former Communist nation in the euro zone, is facing a typically capitalist dilemma: whether to protect creditors of big banks.
Rising loan losses resulting from a housing bust and a second recession in two years have left a hole of about 7.5 billion euros ($9.9 billion) at Slovenia-based lenders, investment bank Keefe Bruyette & Woods estimates. That’s a lot for a 35 billion-euro economy: A bank bailout would push government debt above 70 percent of economic output.
Even after a successful domestic debt sale two weeks ago, the country may need assistance from the European Union, and holders of bank bonds, including the most senior creditors, could be forced to take losses, according to Raoul Ruparel, head of research at London-based Open Europe. Such a bail-in, which would be the second in the euro zone, after Cyprus, risks deepening divergence in the monetary union by keeping borrowing costs higher in economically weak nations.
“It’s not impossible, but it’s very unlikely that Slovenia can manage to pull off the bank restructuring without any EU money,” said Ruparel, who tracks economic and political developments in the region. “And when it turns to official funds, the conditions will most likely include a bail-in of creditors, especially because banks are the main problem.”
Moody’s Investors Service cut Slovenia’s debt rating two levels to junk today, citing potential bank-rescue costs increasing government debt as the main reason for the decision. The country may have to ask for financial aid from the EU as its borrowing costs become unsustainable, the ratings firm said.
“Moody’s expects bank asset quality to continue to deteriorate given the weak economic environment,” the firm said in a statement. Delays by the new government to establish a bad bank “suggest that the sovereign remains heavily exposed to contingent liabilities.”
The central European country delayed the sale of five- and 10-year dollar bonds that it had started marketing this week, following the downgrade. Slovenia became the fifth nation in the 17-member euro region to have its debt rated junk. The downgrade wasn’t a surprise, said Vanguard Group Inc.’s Jonathan Lemco.
“Slovenia has serious problems and the market is not blind to that,” said Lemco, a senior sovereign-debt analyst at the largest provider of U.S. bond funds. “Everyone was looking for a downgrade. Their banking system is in real need of support, although policymakers continue to insist they don’t need a bailout of any kind.”
Slovenia is trying to avoid following Cyprus as the sixth country using the euro to require a bailout. The sale of 1.1 billion euros of 18-month bills gave the government some breathing room. The yield on its dollar bonds due October 2022 has fallen 58 basis points to 5.67 percent since the April 17 sale. Still, the cost of cleaning up its banks may force Slovenia to join Ireland, Spain and Greece in seeking aid and Cyprus in having to impose losses on creditors.
“We need to see the size of the assets that actually will be transferred,” said Christopher Allen, a London-based director at BlackRock’s Fundamental Euro Fixed Income team. “We have to understand whether the valuations of those loans are really realistic.”
The government has injected about 1 billion euros into Slovenia’s three largest banks since 2008, according to data compiled by Andraz Grahek, a managing partner at Capital Genetics, a financial-advisory firm in Ljubljana, Slovenia. The country’s lenders will need an additional 900 million euros by the end of July, the government said in a document last week.
The three biggest banks -- Nova Ljubljanska Banka d.d., Nova Kreditna Banka Maribor d.d. and Abanka Vipa d.d. -- are government-owned or controlled and make up almost half the financial system. They have been buying sovereign debt as foreign investors stay away. About 79 percent of bills sold this year prior to the most recent sale were purchased locally, according to the Finance Ministry. The proportion for the latest sale was 71 percent, the nation’s securities-clearing firm said.
Meanwhile, government debt has more than doubled since 2008, partly because of the cash injections to keep banks alive. Those reciprocal money flows have reinforced the link between sovereign indebtedness and bank solvency that euro-zone leaders vowed last year to break.
The government, in power for less than two months, has pledged to carry out the previous administration’s bank- restructuring plans, including the creation of a so-called bad bank to move as much as 4 billion euros of nonperforming debt out of the lenders and recapitalize them.
Delinquencies account for 20 percent of total loans, and that could rise to 27 percent, KBW estimates. As much as 90 percent of the soured debt is held by locally owned banks whose bad-loan ratio could surge to 34 percent, according to the firm.
That would amount to 5 billion euros for the three biggest lenders, some of which would be absorbed by provisions already set aside by the banks. The government might have to inject 3 billion euros of capital to cover the shortfall and finance the bad bank that will take over the nonperforming assets, KBW said.
The EU aid package might have to be about 8 billion euros because the government needs to finance a widening budget deficit as well as bank restructuring, estimates Mai Doan, a London-based economist at Bank of America Merrill Lynch. The Organisation for Economic Co-operation and Development has criticized the government’s 900 million-euro figure as too low and urged some costs to be borne by owners of bank debt.
The government plans to give banks bonds in exchange for the nonperforming assets they transfer to the bad bank. In an interview yesterday with Delo newspaper, Finance Minister Uros Cufer said the asset-management company to take over the bad loans would have to be established in less than a year.
Prime Minister Alenka Bratusek said she will sell state assets, including government stakes in banks as high as 90 percent of the largest lender, to help pay for recapitalization. That has been met with skepticism by some because of Slovenia’s historical resistance to government divestiture and a lack of investor interest in its banks. Bratusek has promised more- detailed plans.
“The government continues to emphasize it won’t request a bailout, but the pipeline of potential debt issuance in the coming year is quite large,” Doan said. “Investors would like to have a backstop from the EU to comfortably invest in Slovenia’s bank restructuring. The government will resist an EU package until it’s pushed to do it by markets, when yields rise to unsustainable levels.”
The yield on 10-year dollar bonds already exceeds that of Romania, Chile or Mexico. Slovenia had to resort to dollar funding in October to tap emerging-markets investors, an unusual move for a euro-zone country. The yield on Slovenia’s 2018 euro- denominated bond is 4.46 percent, compared with 4.34 percent for Portugal, which is rated two levels below Slovenia, after today’s downgrade.
Slovenia, a nation of 2 million people that accounts for 4 percent of the euro-zone’s economic output, joined the monetary union in 2007. Now its membership may require it to impose losses on senior bank creditors, as Germany leads a chorus advocating such burden-sharing in restructuring costs.
The new bail-in strategy risks widening the gap between lending rates in weaker countries such as Slovenia and stronger ones including Germany, according to Alberto Gallo, head of European credit research at Royal Bank of Scotland Group Plc. That could push struggling economies further into recession and make it more difficult to end the region’s crisis.
Banks in weaker euro-zone countries already pay more interest for deposits, ranging from 2.5 percent to 4.5 percent, while German or Finnish counterparts pay as little as 0.5 percent. That translates to higher lending rates for companies in countries from Slovenia to Spain, hurting efforts to improve their competitiveness with German counterparts.
Nonfinancial corporations in Spain, Ireland, Greece, Italy, Portugal, Slovenia and Cyprus pay an average of 5.4 percent for new loans maturing in one-to-five years, according to European Central Bank data. Companies in Austria, Belgium, Germany, Finland, France and the Netherlands pay 3.3 percent.
“Financial fragmentation isn’t getting any better and causes economic fragmentation within the region,” Gallo said.
Meanwhile, foreign banks operating in Slovenia are leaving or shrinking, which worsens the prospects of an economic recovery any time soon, said Ronny Rehn, a KBW analyst.
“Loans are shrinking in the country, so the economy which is built on local demand is collapsing,” said Rehn, who’s based in London. “We might end up being too bullish on asset-quality assumptions for the banks in the next two years if the economy gets much worse.”
Slovenia joins a growing list of euro-zone countries whose banks have pushed them to the brink of collapse.
Ireland was shut out of bond markets in 2010, when it tried to prop up its domestic banks, whose assets had peaked at four times the nation’s gross domestic product. It agreed to a 68 billion-euro aid package that year.
Spain’s borrowing costs surged to as high as 7.5 percent last year as the government delayed recapitalizing savings banks. The country reached an accord for 100 billion euros of assistance and has so far tapped about half of that credit line.
Cyprus, whose banking system is also eight times the size of its economy, received a 10 billion-euro aid package last month after agreeing to shut its largest bank.
In Ireland, junior bondholders were forced to take losses. Irish leaders, who wanted to penalize senior creditors as well, were rebuked by ECB and EU officials at the time. Two years later those officials demanded that Spain force some losses on subordinated debt of failed banks.
When it was Cyprus’s turn, German and Dutch politicians demanded that a bigger portion of bank-restructuring costs be borne by creditors. Because Cypriot lenders had little debt, depositors with more than 100,000 euros at the two largest lenders face losing as much as 60 percent of their savings.
Slovenia’s banks aren’t as big, with total assets about 140 percent of GDP. They also have enough debt to cover the bail-in amount that European leaders will probably require. The three largest banks have 8.7 billion euros of debt, KBW estimates. OECD and KBW data show that less than 10 percent of that is junior bonds, so senior creditors may have to take losses.
Dutch Finance Minister Jeroen Dijsselbloem initially said the Cypriot rescue would become the new template for the euro zone. While he later recanted, European officials have since moved to speed up implementation of new rules that would institutionalize bail-in of bank creditors. ECB President Mario Draghi said on April 4 that the rules need to go into effect as early as 2015, not be delayed until 2018 as originally planned.
Rehn and Doan said they can’t rule out depositors being included in a bail-in. The European Commission bail-in plan lumps uninsured depositors with other senior creditors, Rehn said. If that model is used in Slovenia, depositors could be forced to share the costs. Draghi has said he favors modifying the proposal to elevate all depositors above other creditors.
The shift from blanket protection of almost all bank creditors to demanding they share restructuring costs has contributed to higher borrowing costs for the financial institutions in the weaker countries, RBS’s Gallo said. Banco Santander SA, Spain’s largest lender, pays 4.875 percent for 10- year senior bonds, compared with 2.375 percent for Deutsche Bank AG, Germany’s largest, data compiled by Bloomberg show.
The impact also can be seen in the cost of insuring subordinated debt at the weakest banks in the weakest economies. Credit default swaps to protect against losses cost about 10 percent for Italy’s Monte dei Paschi di Siena SpA and 7 percent for Spain’s Banco Popular Espanol SA (POP), according to Bloomberg data. That translates to 1 million euros to insure 10 million euros of Monte Paschi junior bonds against default annually and 700,000 euros to insure the same amount of Banco Popular debt.
CDS on Monte Paschi’s senior debt costs about 6 percent and Banco Popular’s is about 5 percent. Comparable credit-insurance for UniCredit SpA, Italy’s largest bank, is about 3 percent for senior debt and 5 percent for subordinated.
The divergence between junior and senior debt rates, as well as between weaker and stronger banks, is healthy for the long-term functioning of the banking industry, RBS’s Gallo said.
“This is how it’s supposed to be -- higher risk of failure being reflected in the cost of borrowing by the institution,” Gallo said. “So smaller, second-tier banks are paying more to borrow, but partly because the biggest banks are too big to fail and investors still believe governments will rescue them.”
In the short run, the divergence in borrowing costs between weaker and stronger countries hurts economic recovery efforts. Banks paying more to borrow have to lend at higher rates.
That’s partly because French, German and U.K. banks have been reducing their lending to banks and companies in southern European countries. In 2010, when Ireland had to bail out its banks and was prevented from imposing losses on creditors, lenders based in those three countries had $112 billion of exposure to the Irish banking system. By the end of September 2012, that was down to $31 billion, according to the Bank for International Settlements.
While a country breakdown showing who owns Slovenia’s bank debt isn’t available, total foreign exposure to lenders in the Adriatic nation fell by 50 percent in a year to $3 billion at the end September, BIS data show.
“Now that the bankers have run away from the periphery, German and French politicians no longer care about bank creditors,” said Paul De Grauwe, an economics professor at the London School of Economics. “Germany now says taxpayers shouldn’t bear the costs of bank restructuring, but what it really means is German taxpayers shouldn’t. Slovenian or Cypriot people are stuck with the costs since German bankers are gone.”
Slovenian taxpayers may wind up better off than their Cypriot counterparts because their banking industry is smaller, according to Timothy Ash, chief emerging-markets economist at Johannesburg-based Standard Bank Group Ltd. The government needs to move fast to detail its restructuring plans and seal a deal with the EU to keep those costs under control, he said.
“It’s all manageable unless there’s a run on the bank,” said Ash, who’s based in London. “The longer you mess around, the higher possibility for such a run to happen. They need to get serious soon. If they wait too long, they’ll be toast.”
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