Breaking free of Europe's bonds

For too long, European leaders have been acting in the interest of banks under the banner of saving the euro. If things are going to change, however, the link between sovereign and bank debt must be broken.

Throughout the European debt soap opera, Europe’s leaders have expressed their willingness to 'do whatever it takes' to restore stability and save the euro. This column argues that, too often, policymakers have in fact been 'doing whatever it takes' to serve the banks.

After initial denials, Europe’s leaders have started to acknowledge that IMF Chief Christine Lagarde was right. Through their statements and decisions, policymakers are showing their agreement with her assessment in August 2011 at the Federal Reserve’s Jackson Hole symposium that there was an urgent need for recapitalisation of Europe’s banks.

This recognition of reality is the good news. The bad news is the EU’s bank recapitalisation is being handled in a way that will make a recovery from the Europe’s debt crisis more problematic than it needs to be. There are five concerns, which I will address in turn:

- Incentives for deleveraging;
- Absence of firm guidelines on dividends and executive compensation;
- Omissions of a recession scenario and of an unweighted leverage ratio from the stress tests;
- Inequitable burden-sharing during debt restructuring; and
- Insufficient measures to permit an escape from the adverse feedback loop between sovereign debt and bank debt.

Pro-cyclical deleveraging

First, by specifying the new bank capitalisation target (a 9 per cent Core Tier ratio) as a ratio to risk-weighted assets rather than converting that ratio into a target for increases in bank capital alone, the European Banking Authority has increased the risk of a pro-cyclical response in a region where economic growth is fragile and weakening further.

This is because many banks may choose to reach the higher capital ratio as much by decreasing the denominator (shedding bank assets) as by increasing the numerator (raising bank equity). As an impressive body of research has shown, increasing bank equity need not be expensive or adverse for the real economy because the higher equity cushion makes bank equity safer and because the marketplace puts a positive value on such increased safety; in contrast, reaching a higher capital ratio by restricting loan growth to the real economy and by engaging in fire sales of bank assets has an unambiguous contractionary effect.

Yes, the December 2011 EBA recommendation does specify that sale of sovereign bonds (after September 30, 2011) will not count toward meeting the higher capital ratio and that national regulators, in consultation with the EBA, will seek to ensure that recapitalisation does not lead to "… significant constraints on credit flow to the real economy”. But some loopholes have already been agreed (eg, for orderly deleveraging plans agreed to before October 26, 2011).

Also, as they did in the negotiations over the Basel III agreement, European banks (and perhaps some national regulators as well) will likely press for – and may well extract – other concessions – both in the run-up to and after individual-bank recapitalisation plans have been submitted in early January 2012.

In any case, the EBA’s recommendations are not legally binding on national regulators. Indicative of the gap that could well develop between the EBA’s intentions and bank outcomes, a recent Morgan Stanley study estimated that European banks are likely to shed €1.5-€2.5 trillion of bank assets over the next 24 months.

Dividends and executive compensation

A second misjudgement was not to announce simultaneously (with the higher bank capital target) a firm EU-wide policy on bank dividends and compensation. The December 2011 EBA recommendation advises banks to tap private-sector sources of finance first for recapitalisation but stops well short of issuing any firm guidelines on either dividends or compensation.

Any EU bank that was below the capital target should have been directed to stop paying dividends until it reached the new capital target and until it was not in danger of falling back below it over the next year. Clearly, some large and under-capitalised EU banks are operating under no such constraints.

- Banco Santander, for example, is reported to be paying its shareholders at least €2 billion in cash and more in stock in 2011 – at the same time as regulators estimate that it has a capital hole of at least €15 billion.

- BBVA, Deutsche Bank, and BNP are among others that are expected to be making significant dividend pay-outs at the same time as they are seeking to raise capital. All of the banks mentioned were judged to be below the 9 per cent Core Tier 1 capital ratio in the December 9, 2011 EBA bank stress test).

Any EU bank that is not able to reach the new capital target exclusively by tapping private sources and has to rely on government support should also have been directed to meet strict guidelines on executive compensation.

Some will argue that such an approach is too interventionist. But a time when the eurozone is in a deep debt and banking crisis and when banks are recipients of a massive subsidy in the form of unlimited three-year liquidity support from the ECB (at 1 per cent interest and softer collateral requirements), not requiring a something substantial from the banks in exchange is indefensible.

Weakness of the stress test

Yet a third concern has to do with remaining weaknesses in the bank stress tests conducted by the EBA – weaknesses that are contributing to uncertainty about the creditworthiness of EU bank counterparties and that also partially explain why eurozone banks have made record cash placements with ECB Deposit Facility. Although the latest stress test improved disclosure and pricing for sovereign debt holdings (now covering both the banking and trading book) and aimed for a higher capital ratio, it still fell short in two important respects.

1. The stress scenario covered mark-to-market losses on sovereign bonds but did not incorporate any adverse macroeconomic scenarios for the eurozone – and this despite a consensus downward revision of growth forecasts for the region in 2012. Both kinds of risks are relevant in assessing the health of individual EU banks.

2. Bank capital positions were assessed only against a risk-weighted standard and not also against an unweighted leverage target.

By now it is widely appreciated that, due to political considerations and gaming/regulatory arbitrage by the banks, the Basel risk weights do not reflect true economic risk.

For example, despite all that has happened with sovereign debt in the periphery countries, sovereign bonds still carry a zero risk weight in the calculation of risk-weighted assets. Recognising these problems and over the strong opposition of the banking industry, the Basel III agreement introduced for the first time a minimum unweighted leverage requirement for bank capital (along with the risk-weighted minimums). If investors (and banks themselves) are to be able to distinguish healthier banks from the weaker ones, a leverage test for EU banks is essential – especially in light of the finding in the IMF’s September 2011 Global Financial Stability Report that EU banks were on average about three times as leveraged as US banks.

Burden-sharing during debt restructuring

Concern number four is with equitable burden-sharing during sovereign debt restructuring. At its December 9 meeting, the European Council decided to reverse its earlier position on private-sector involvement; it announced that private-sector burden-sharing would no longer be required beyond the restructuring of Greek sovereign debt.

The Council’s defence of this view was that the Greek situation was "exceptional” and "unique”; presumably, the Council was also motivated to limit future bond-market contagion based on fears that private-sector holders of some other eurozone sovereign bonds were facing losses. But official proclamations that no other eurozone countries will need to restructure their debts does not make it so, and even legitimate worries about contagion do not answer a key question:

If private-sector holders of beleaguered eurozone sovereign bonds – including eurozone banks – are to be exempted from such potential losses, who is going to absorb them?

Neither the IMF nor the ECB seem to be rushing forward to give up their de jure or de facto preferred creditor status. All of this just increases the odds that future bank losses on sovereign debt will ultimately be assumed by the public sector and by taxpayers in the highly indebted countries – much to the detriment both of public-debt sustainability and of sustained public support for adjustment programmes. Once again, coddling the banks will impose higher costs on the rest of society.

The sovereign and bank debt tangle

Last but not least, there is the broader concern of how the eurozone can escape the adverse feedback loop operating in both directions between sovereign debt and bank debt. Some would argue that nothing needs to be done beyond what already is done or has been set in motion:

- A new tougher fiscal compact;
- New more market-friendly governments and strengthened adjustment programmes in Greece, Portugal, Spain, and Italy;
- A 9 per cent bank capital target; and
- Increased official crisis financing of various kinds via the EFSF, European Stability Mechanism, ECB, and IMF.

I hope so, but I seriously doubt it.

Among other things, the ‘competitiveness problem’ between Germany and the periphery countries is yet to be addressed seriously; there are likely to be further debt restructurings after Greece that will require increased bank recapitalisation beyond the current 9 per cent target; and a credible plan to rekindle growth in the eurozone has not yet been put forward – much less agreed upon.

I am likewise sceptical that the answer to bank recapitalisation is to have european banks load up on the new carry trade, made possible by the now sizeable spread between the interest rate on three-year loans from the ECB and those on sovereign debt of the periphery countries. By increasing their holdings of such bonds, banks will become even more vulnerable to negative developments on sovereign debt; and this dependency, in turn, could produce an even greater reluctance to consider sovereign debt restructurings when they are necessary, as well as an inequitable deal on burden-sharing between the bank creditors and taxpayers if and when such restructuring becomes inevitable.

How to break the link?

The most interesting operational question on breaking the link between sovereign debt and bank debt is what can be done short of the creation of eurobonds and/or very largescale purchases of sovereign debt by the ECB – if agreement on either of those ‘bazookas’ continues to be elusive.

To my mind, the best answer thus far has been provided by the recent proposal by Markus Brunnermeier, et al, to create what they call "European Safe Bonds”. In short, their proposal offers a way both to make ‘safer’ the holdings of eurozone bonds by eurozone banks (via a combination of diversification, tranching of returns, and a publically financed credit enhancement) and to entice more non-banks with higher risk tolerances (inside and outside the eurozone) to hold the riskier tranche of those bond returns. Moreover, the proposal avoids many of the operational shortcomings and incentive problems of its current competitors and failed predecessors, including the EFSF and private-sector Collateralised Debt Obligations-like schemes. If this plan is not yet getting serious attention (privately) within official eurozone circles, it ought to be.

To sum up, throughout this European debt and banking crisis, eurozone leaders have expressed their determination to "do whatever it takes” to restore stability and save the euro. But if one examines the stance the official sector has taken toward banks, it looks much more like eurozone leadership "takes (sheepishly) whatever its large banks do” – even when those actions are much more in the banks’ narrow interest than in the wider public one. It is high time for a change.

Originally published on Reproduced with permission.

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