Europe Banks Fail to Cut as Draghi Loans Defer Deleverage
(Corrects list of banks in second paragraph of story originally published Sept. 18.)
European banks pledged last year to cut more than $1.2 trillion of assets to help them weather the sovereign-debt crisis. Since then they’ve grown only fatter.
Lenders in the euro area increased assets by 7 percent to 34.4 trillion euros ($45 trillion) in the year ended July 31, according to data compiled by the European Central Bank. BNP Paribas SA (BNP) and UniCredit SpA (UCG), the biggest banks in France and Italy, expanded their balance sheets in the 12 months through the end of June.
They have Mario Draghi to thank. The ECB president’s decision nine months ago to provide more than 1 trillion euros of three-year loans to banks eased the pressure to sell assets at depressed prices. The infusion, designed to encourage firms to lend, succeeded in averting a short-term credit crunch by reducing their reliance on markets for funding. It also may be making European lenders dependent on more central-bank aid.
“Deleveraging isn’t taking place, especially in Spain and Italy,” said Simon Maughan, a bank analyst at Olivetree Securities Ltd. in London. “The fact that we haven’t got on with it, or very slowly, suggests that when the time comes we’ll need another ECB injection to roll over the first one, just to keep the balance sheets of Italian banks in business.”
European banks said last year they would cut assets within two years by more than 950 billion euros, about 3 percent of the total, according to data compiled by Bloomberg. By selling divisions and loans and reining in lending, the firms were seeking to reassure investors they would be able to reduce short-term funding needs and increase capital.
Total assets at financial institutions in 17 euro-zone countries stood at 32.2 trillion euros in July 2011, according to the ECB, more than triple the euro area’s gross domestic product last year.
Analysts predicted that European lenders would have to shrink more as regulators requested higher capital and investors, who became less convinced that governments would be able or willing to bail out their largest banks, demanded bigger returns for lending to those firms.
Alberto Gallo, a London-based analyst at Royal Bank of Scotland Group Plc (RBS), estimated last year that lenders would have to eliminate as much as 5 trillion euros of assets over five years. The International Monetary Fund predicted in an April report that banks would shrink by as much as $3.8 trillion and curb lending, moves that could cut euro-area GDP by 1.4 percent.
The ECB’s longer-term refinancing operation, or LTRO, changed the timetable. The Frankfurt-based central bank extended 489 billion euros of three-year loans to European banks in December in the first phase of the program. Two months later, it loaned 530 billion euros to 800 firms.
“Thanks to Draghi, the massive shrinkage that was looming six months ago across Europe isn’t happening -- at least not yet,” said Nikolaos Panigirtzoglou, an analyst at JPMorgan Chase & Co. in London. “That’s what the economy needed on the short term.”
Rather than shrinking, lending to households and companies in the euro area held steady this year, ECB data show. Total loans rose to 18.6 trillion euros as of July 31 from 18.5 trillion euros at the end of 2011. The figure masks a decline in countries worst-hit by the crisis, such as Spain and Greece. Lending in Spain fell 5 percent to 1.6 trillion euros in the year through July 31, according to Spanish central bank data.
“The supportive impact of the non-standard measures announced by the euro-system in December 2011 prevented abrupt and disorderly deleveraging, which could have had severe consequences for the economy,” the ECB said in its monthly report published Sept. 13. A central bank spokeswoman declined to comment further.
Banks across Europe bolstered capital instead of selling assets and curbing lending. They did it by retaining profit and swapping debt with other securities, such as subordinated debt, considered to have better loss-absorbing qualities, the European Banking Authority said in July.
Some lenders used the ECB’s loans to purchase sovereign bonds. Under current Basel Committee on Banking Supervision rules, banks don’t have to hold any capital against government debt because it’s considered risk-free.
Basel rules require banks to maintain varying amounts of capital against assets depending on their riskiness. They allow the largest firms to use their own models to calculate how much capital they need. By adjusting the criteria or swapping assets for ones considered less risky, lenders can reduce their risk- weighted assets, even as total assets increase.
The purchase of sovereign bonds boosted total assets at euro-zone banks by about 500 billion euros, according to JPMorgan’s Panigirtzoglou. An increase in volatility forced lenders to mark up the value of derivatives holdings by another 500 billion euros, as it became more expensive for investors to protect themselves from losses, he said. Excluding those two increases, assets have remained almost unchanged, he said.
By reinvesting LTRO funds in higher-yielding securities such as government bonds, banks can reap about 12 billion euros of profit a year, or 10 percent of the total, helping them meet higher capital requirements, Panigirtzoglou estimated.
The 38-company Bloomberg Europe Banks and Financial Services Index has climbed 17 percent this year, outpacing the Euro Stoxx 50 Index (SX5E), which has gained 12 percent.
The ECB money has removed the incentive for banks to clean their balance sheets, according to Olivetree’s Maughan.
“Some banks, especially in Spain and Italy, are just taking in the money that they can get from the ECB, which should be a short-term measure in order to enable them to manage while they implement structural reforms,” Maughan said. “It successfully staved off a funding crisis, but its real aim of facilitating restructuring hasn’t even started.”
For lenders in southern European countries, the strategy may not be as risk-free as it looks. Yields on bonds sold by the governments of Spain and Portugal hit euro-area records this year on investor concern that they would require bailouts.
Yields on Spanish 10-year government bonds increased to 5.97 percent on Sept. 14 from about 4.2 percent two years ago, down from their 7.75 percent high on July 25. Similar Italian bonds rose to 5.11 percent from 3.93 percent in the same period.
Intesa Sanpaolo SpA (ISP), Italy’s second-largest bank, will continue to purchase Italian government bonds, Chief Executive Officer Enrico Tommaso Cucchiani, 62, said in an Sept. 7 interview at a conference in Cernobbio. The Milan-based bank boosted its holding of Italian government bonds to more than 80 billion euros in June from 64 billion euros a year earlier. Total assets rose by about 3 percent to 666 billion euros in the year ended June 30.
UniCredit (UCG) increased assets by 4 percent to 955 billion euros in the same period. CEO Federico Ghizzoni attributed the rise in part to the ECB loans and reiterated the Milan-based bank’s desire to shrink.
“The issue of deleveraging is still considered one of the most important things that need to be achieved,” Ghizzoni, 56, said in an interview in Cernobbio. “But only talking in terms of shrinkage is a bit dangerous internally for the bank because it doesn’t encourage employees to do business. To be balanced you have to look where it makes sense to stay.”
Banks trying to sell assets are finding that buyers are demanding steep discounts for their worst assets, according to executives at private-equity and hedge funds acquiring the loans. They’re seeking discounts of as much as 50 percent to face value for underperforming loans, said Andrew Jenke, a director at KPMG LLP in London who advises on such transactions. Selling a loan at a discount to the value marked on the books requires the bank to crystallize a loss that erodes capital.
British and Irish lenders are selling the most because European Union regulators have forced them to divest divisions and loans in return for state aid.
RBS (RBS), which received a 45.5 billion-pound ($74 billion) rescue in 2008, cut assets to 1.4 trillion pounds at the end of June from 2.4 trillion pounds at the time of its bailout. The Edinburgh-based lender last week began selling a stake in its Direct Line insurance unit in an initial public offering after struggling to attract private-equity bidders.
Lloyds Banking Group Plc (LLOY), which got a 20.3 billion pound bailout, has trimmed about 66 billion pounds from its balance sheet since 2009, taking it to 961 billion pounds. Assets at HSBC Holdings Plc (HSBA), which didn’t seek a bailout, were $2.65 trillion in June compared with $2.69 trillion a year earlier.
Allied Irish Banks Plc (ALBK), Bank of Ireland Plc and Permanent TSB Group Holdings Plc have eliminated 42.6 billion euros of assets, more than half the 70 billion-euro target they have to meet by the end of 2013.
Banks in other European countries have sought to sell performing loans, which carry higher prices, or some of their best assets to avoid taking too big a loss that would deplete capital. Some also have changed their mix of assets to reduce the amount of capital they need to hold.
BNP Paribas, Societe Generale SA (GLE) and Credit Agricole SA (ACA) have cut back on dollar-denominated lending to aerospace and shipping companies, which carry a 100 percent risk-weighting under Basel rules, forcing banks to set aside capital equal to the money they lend.
The three French banks posted increases in total assets and decreases in risk-weighted assets. While derivatives explain some of the gain, the trend is “intriguing,” said Christophe Nijdam, an analyst at AlphaValue, a Paris-based research firm.
BNP Paribas’s risk-weighted assets declined by about 6 percent in the six months through June 30, and Societe Generale’s dropped 2 percent. Credit Agricole’s risk-weighted assets fell 9 percent in the same period. Total assets at the three banks climbed during the six months.
“What should we believe, the RWAs, that are often based on internal models, or assets defined by international accounting standards?” Nijdam said. “A reduction of risk-weighted assets doesn’t reduce funding needs. Only a reduction in gross assets does. French banks are still way too big to fail.”
BNP Paribas said last month it achieved 90 percent of its planned 79 billion-euro cut in risk-weighted assets by the end of June. Credit Agricole said it completed 97 percent of a planned 35 billion-euro reduction in risk-weighted assets by the same date. Societe Generale trimmed risk-weighted assets at its investment-banking unit by 33 billion euros.
Still, the three banks boosted their total assets by 2.3 percent, 13 percent and 7.6 percent, respectively, in the 12 months through the end of June. French lenders increased their reliance on ECB funds to 124.5 billion euros as of Aug. 7, from 32.3 billion euros a year earlier, according to Nijdam, based on his analysis of French central bank data.
Societe Generale sold its U.S. asset-management unit, TCW Group Inc., last month to private-equity firm Carlyle Group LP (CG) for less than the $880 million it paid in 2001, according to people familiar with the transaction. The Paris-based lender also is close to selling 800 million euros of mortgages to Axa SA’s real-estate unit at a discount of less than 10 percent of face value, people with knowledge of the deal said last month.
“The bulk has been done” in adjusting the balance sheet, Societe Generale CEO Frederic Oudea, 49, said in a Sept. 12 interview with Bloomberg Television. “I am happy with the structure of the liquidity today, and there’s plenty of liquidity in the market. We have started the disposal program, and we’re going to carry on that in the next few quarters.”
Spokesmen for Societe Generale, Credit Agricole and BNP Paribas declined to comment.
Deutsche Bank AG (DBK), Germany’s largest lender, plans to reduce risk-weighted assets by 135 billion euros in a process co-CEO Anshu Jain, 49, said last week would be “very rapid.” Total assets had swollen to 2.2 trillion euros in June from 1.85 trillion euros a year earlier.
Spanish banks, which will receive as much as 100 billion euros from the EU to boost capital, also may accelerate deleveraging after the government opens a so-called bad bank to take on souring real-estate loans from rescued lenders.
Assets at Banco Santander SA (SAN), Spain’s largest lender, expanded by 5 percent to 1.29 trillion euros in the 12 months ended June 30 in part because lending in Latin America and the U.S. offset declines in Spain and Portugal. Risk-weighted assets fell 3.3 percent in the period, the company said. A spokesman for the bank declined to comment.
Analysts estimate the pace of asset sales will increase as banks face the next round of Basel rules, which go into full effect by 2019. To comply, lenders will need to raise about 400 billion euros of core Tier 1 capital, the highest quality of capital mostly made up of common stock, the EBA said. Firms may still try to meet that requirement largely by retaining earnings, which would be possible if profits remain stable, according to Panigirtzoglou.
By providing money and removing the pressure on banks, Draghi has delayed necessary steps to shrink, Maughan said.
“The banks are the weak link in the economy,” he said. “They have to be compelled to sell assets. If you let them do it in their own timeframe, they will wait.”
That could lead to what RBS’s Gallo called the “Japanification” of the banking system, a prolonged period during which lenders are slow to clean up their balance sheets.
“We’ve gone from a risk of an accelerated deleveraging to the opposite,” he said. “It’s a better scenario for the economy, although it shouldn’t translate into complacency.”
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