Evercore Pan Asset

The Future of the Euro area

The Euro crisis is especially worrying given the state of the European banking system. In practice the EU member states stand behind their major banks. State finance and bank finance is almost one and the same thing. Problems in banks require state support, as recently seen in Ireland. The more the member states put money into their banks, the worse the deterioration in their own finances and the more strains are placed on their government bond markets.

The EU authorities understood this and undertook stress tests of the main banks in their system. They published the results in July 2010, showing that seven banks out of 91 studied needed additional capital to have sufficiently strong balance sheets to withstand a double shock. The Committee of European Banking Supervisors confirmed that no major bank studied was insolvent, and that all had sufficient capital to survive even if the two shocks materialised.

The authorities envisaged the right kind of shocks. They proposed that there could be a double dip recession, with no growth in 2011. They argued that there could be losses on EU member states government bonds, commonly held by banks as assets.

The problem with the stress tests, mentioned extensively by commentators at the time, was they were not particularly stressful. The test to ensure banks could cope with a sovereign debt problem only wrote sums off the bonds held in banks’ trading books. The Regulators assumed that the longer term holdings of bonds by the banks were fine as they could hold them to maturity and would not therefore incur losses. The stress test assumed a 75 basis point increase in 10 year borrowing rates (an additional 0.75%) and another 70 basis points on top for the EU average to allow for markets pushing up the borrowing rates of weaker countries by more.

These figures led the testers to cut 23% off the value of Greek bonds, 12.3% off the value of Spanish bonds, 12.8% off the value of Irish bonds, 14% off the value of Portuguese bonds, 10.2% off K bonds and 4.7% off German.

As we have seen in the Greek and Irish crises, the markets can be more punishing than this. Yields on 10 year Greek debt have risen to 12% and on Irish to over 9% compared to 2/5% on German. Banks do lose money on their holdings as well as on their trading books, if you mark the bond value to market prices. There is also an impact on confidence and the valuations of other assets like property in the affected countries which might also damage the banks.

 The Stress tests revealed that five Spanish banking groups would have Tier One ratios below 6% if the conditions of the tests took place. Diada (3.9%), Espiga (5.6%), Civica (4.7%), Unnim (4.5%) and Cajasur (4.3%) were all thought to need extra capital. The German Hypo Real Estate bank and the Agricultural Bank of Greece also failed the test.  Several others were close to the 6% cut off, including Allied Irish and the Greek bank, Piraeus. 

Investors in recent days have worried that a more severe test should have been applied. Banks could lose more on their government bond holdings than imagined. In addition, the property sectors in Ireland and Spain are weak, with rising amounts of empty property and falling prices in many locations. Property remains a fundamental underpinning of banking activity, representing a high proportion of the collateral used for loans.

So what should the authorities do? In the short term there need to be reassuring statements from the European Central Bank that it stands ready to offer whatever liquidity these banks need. As all the main banks in the European system are said to be solvent and creditworthy according to their EU Regulators, the Central Bank has to ensure they stay liquid even if the market loses confidence in them and withdraws funds.

In addition it looks as if the banking Regulators need to work behind the scenes with the most vulnerable banks, and agree an action programme with each to raise its ratios and cut its risks. Banks can do this by selling assets, making more profit, selling whole businesses to others, writing off bad debts and losses, raising new capital, merging with better capitalised rivals and in a number of other ways. When they reach an agreement with a vulnerable bank about a clear way forward this should then be announced to the markets so they can see that their doubts and worries are misplaced.

All this will be easier if the economies of western Europe are growing. Consumer debt is less risky if people have jobs and can look forward to rising wages. Business loans are less risky if business is expanding and turnover rising. Property debt is less risky if property is in demand and rents have stopped falling.

How can they defend the Euro?

The EU officials who are planning how to save the Euro are following a policy of requiring stricter spending controls and reduced borrowing from the member states, whilst at the same time expanding their own spending and powers to bring the Union  under a stronger centre.                 

There are four elements to the approach. The first is to offer loans on quite expensive terms to any state that needs financing. Greece and Ireland have been through the process. The Union is able to use the loan negotiations as a means to exerting more control over the budget of the state concerned. There might be more such bail outs. The cost of Portuguese, Spanish and Italian borrowing is rising despite the Irish bailout “to stop contagion.”

The second is to tighten discipline over the budgets of all member states. The weaker ones are meant to take heed of what is happening to the states going through bail out, and cut enough off spending or put taxes up sufficiently to avoid a similar fate.

The third is to take new powers for the Union to control budgets more strictly in future, limiting the amount any state can borrow in the common currency. States will  be fined or made to lodge special deposits with the centre if they are errant. This way the Union hopes to avoid a repeat of the current debt crisis.

The fourth is to impose new rules on how states borrow after 2013. They will require states to put a clause in any loan agreement to say that if the state gets into difficulties it may reduce the amount of interest or the amount of capital it repays. This would replace the current de facto decision of the Union to bail out member states so they can repay existing borrowings.

This is a compromise policy which is unlikely to work. If they succeed in controlling budget deficits after 2013 the warning to the bond markets is needless. In the meantime it is spooking markets and making it more difficult for states to raise money. Preventing a future problem does not solve the current one.

Markets are unimpressed by the bail outs, because they fail to address the underlying problem, the lack of growth in the struggling states. Without growth, cutting the deficits and paying the interest is going to be very difficult if not impossible. The EU’s policy has led it to forecast no growth for Greece and Portugal next year.

On Thursday the European Central Bank confirmed that for the time being it will try to support Euroland banks, making liquidity available as required until the end of March. They also implied they will buy some more sovereign debt bonds from within the Euro area where the yields seem too high.

We continue to advise against holding EU bank shares or EU sovereign bonds in non Euro accounts, and to avoid the risky Euro sovereign bonds and bank shares generally.  This crisis is not yet resolved, and the authorities have an uncertain touch.