Europe’s Banks Stressed by Sovereign Debts Regulators Ducked

Mervyn King, governor of the Bank of England
Mervyn King, governor of the Bank of England, pauses during the bank's quarterly inflation report news conference in London on May 12, 2010. Photographer: Chris Ratcliffe/Bloomberg

Even after a 750 billion euro ($960 billion) bailout for the weaker economies in the euro zone, investors are skittish about sovereign debt -- and about the banks that hold the region’s government bonds.

A default by Greece could trigger the collapse of banks with large sovereign-bond holdings, says Konrad Becker, a financial analyst at Merck Finck & Co. in Munich. “A default by one EU country would lead to an evaporation of trust in banks,” he says. “If investors aren’t willing to invest in banks anymore, then many banks will go bust in months, not years.”

The new concern about the fragility of the region’s banks comes as politicians and regulators are eager to claim progress in fixing the global financial system, almost two years after credit markets cracked, Bloomberg Markets magazine reports in its October issue.

The European Union has stress tested 91 lenders, giving 84 of them passing grades. In the U.S., President Barack Obama in July signed the biggest package of new U.S. banking laws since the Depression. The Basel Committee on Banking Supervision, meanwhile, is readying new capital and liquidity rules for world leaders to agree upon when the Group of 20 meets in Seoul in November.

Europe, however, faces a special challenge in righting its banks: the sovereign-debt crisis. Europe’s largest financial companies hold more than 134 billion euros in Greek, Portuguese and Spanish government bonds, according to a tally in May by Bloomberg News based on interviews and company statements.

Greek Debt

Even after the EU and International Monetary Fund worked out the rescue plan in May, investors are still demanding a high premium for buying Greek debt. As of Sept. 3, the yield was 11.28 percent on 10-year Greek bonds compared with 2.34 percent on similar German bonds. At the end of August, the gap between the two, the yield spread, was the widest it has been since the peak in May, just before European leaders agreed on the bailout.

Yields on Irish bonds jumped after Standard & Poor’s on Aug. 24 cut the country’s credit rating one step to AA-, citing concern that the rising cost of supporting Ireland’s struggling banks will increase its budget deficit. The yield spread versus German bonds climbed to the highest in at least 20 years.

The hesitancy among investors also shows up in the spreads on bank bonds, with some European institutions paying higher borrowing costs compared with their U.S. counterparts.

As of Sept. 2, buyers demanded an extra 383 basis points, or 3.83 percentage points, over the yield on government debt to own 5- to 10-year bonds sold by Paris-based BNP Paribas SA, according to Bank of America Merrill Lynch index data. The comparative premiums were 275 basis points for Citigroup Inc. bonds and 192 basis points for JPMorgan Chase & Co. bonds; both of those banks are based in New York.

‘Still Badly Damaged’

“We face a banking system that is still badly damaged and which is still trying to repair its balance sheets,” Bank of England Governor Mervyn King said on Aug. 11 at a press conference in London. “It has to raise funding at very high costs, and that makes it difficult for banks to lend.”

Lenders have been slow to raise the capital they need. With yields on European bank debt so high, the market has shrunk. The region’s banks, including U.K. lenders, sold about 18 billion euros of debt in August, the smallest amount for the month since 2004.

Many European institutions continue to rely on central banks for funding. In July, the European Central Bank loaned 132 billion euros for three months to 171 financial institutions. ECB President Jean-Claude Trichet on Sept. 2 extended emergency lending measures for banks into 2011. The bank will keep offering unlimited one-week and one-month loans until at least Jan. 18, and will offer additional three-month funds in October, November and December.

Parking Money

Wary of lending to each other, banks are also using the ECB to hold record amounts of their cash. On June 9, euro-zone lenders deposited a record 369 billion euros overnight at the ECB, more than in October 2008, during the credit meltdown.

“The amount banks have parked at the ECB is just outrageous,” says Florian Esterer, a fund manager at Zurich-based Swisscanto Asset Management AG who invests in financial stocks, including Commerzbank AG and Royal Bank of Scotland Group Plc.

The bank-stress-test results, published on July 23, should help restore investor faith in the region’s financial industry, Trichet said at a press conference on Aug. 5. Still, those examinations fell short of addressing the possibility of a default by a euro-zone country.

Not Tested

Regulators believe the May bailout will succeed, says David Green, who was head of international policy at Britain’s Financial Services Authority from 1998 to 2004. “It would be quite perverse for governmental agencies to assume that the program isn’t going to work,” he says.

The tests covered government bonds held by banks for possible sale -- not those held as reserves on their balance sheets. Europe’s banks only have to write down sovereign debt in their reserves if there’s significant doubt about a country’s ability to repay in full or make interest payments. The region’s lenders have about 90 percent of their Greek sovereign debt on their balance sheets, according to a survey by Morgan Stanley.

Europe’s governments can’t afford to question the quality of bonds they’ve sold to banks, says Chris Skinner, chief executive officer of Balatro Ltd., a financial industry advisory firm in London. “Bankers have got Europe’s governments in their pockets, primarily because politicians cannot change the way lenders do business without undermining confidence in sovereign debt,” he says.

Toxic Assets

While they’re stuck with their government bond holdings, Europe’s banks are also still carrying much of the troubled assets they had during the 2008 meltdown. Euro-zone lenders will have written down about 3 percent of their assets from the peak of the credit crisis by the end of 2010, compared with 7 percent for U.S. banks, the IMF estimated in April. The steeper writedowns by U.S. banks are partly because they held a higher proportion of securities, the IMF said.

That doesn’t excuse the lack of candor shown by many European lenders about the unsellable assets on their books, says Raghuram Rajan, a finance professor at the University of Chicago. “European banks haven’t owned up to the large amounts of toxic debt that they hold,” says Rajan, who was chief economist at the IMF from 2003 to 2007.

“The stress tests weren’t severe enough,” says Julian Chillingworth, who helps manage $21 billion at Rathbone Brothers Plc, an investment firm in London. “Many bond investors aren’t convinced the Greeks are out of the woods.” And if the Greeks haven’t emerged from their crisis yet, then neither have the European banks that hold their debt.

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