Tags: europe | banks | cycle

European Countries, Banks in Pernicious Cycle

Thursday, 14 Jun 2012 03:10 PM

 

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A pernicious relationship between troubled European countries and their equally troubled banks is dragging both sides down, and policymakers' attempts to solve the problem are often only making matters worse, especially in Spain.

Some eurozone governments and banks in their countries are finding it ever harder to raise funds on nervous financial markets, forcing each side to rely increasingly on the other for help and accelerating the downward spiral.

As governments are forced into bailing out their banks, so their sovereign credit ratings suffer and foreign investors shy away from their bonds. This means the governments depend ever more on domestic banks - often the very lenders they are rescuing - to buy up their debt and fund their budget deficits.

Spain has shown the problem clearly in the past week. On Saturday it requested up to 100 billion euros ($126 billion) in eurozone aid to fund a bailout of banks hit hard by a recession and the collapse of a property boom.

Then on Wednesday, Moody's agency slashed Spain's rating by three notches to Baa3, saying the new rescue plan would increase its debt burden. The move left Spain only one rank above "junk" status, which would dramatically increase funding costs for both the sovereign and the banks.

" Crucially ... rather than weaken the pernicious inter-relationship between bank and sovereign that has exposed Spain to ever mounting contagion pressure, this bailout has made it stronger," analysts at Rabobank said.

Funding problems for Spanish banks will deepen if Moody's cuts the sovereign rating further to "junk" status, or if other agencies follow its lead.

DBRS, a ratings agency used by the European Central Bank to rate collateral, said on Thursday it too was preparing to cut Spain's rating. This would force banks to pay an additional 5 percent penalty for using Spanish sovereign bonds as collateral for borrowing from the ECB.

With commercial funding increasingly hard to raise, Spanish banks' ECB borrowings hit a record 324.6 billion euros in May.

Lower sovereign ratings in Spain would also make all kinds of other financial transactions, such as clearing futures and derivatives trades, costlier for banks as they are forced to stump up more government bonds as collateral.

There are also worries about the rising scale of banks' holdings of their own country's bonds.

Spanish banks held 146 billion euros of domestic government bonds at the end of April, almost double the 76 billion they held in December, according to Spanish Treasury data.

In Greece, the first eurozone country to succumb to a debt crisis in 2009, commercial banks have paid a heavy price for holding huge amounts of their government's debt.

The country's four biggest banks lost 28 billion euros under a restructuring deal earlier this year that wiped out 74 percent of the value of the debt.

Similar worries are stalking Italy, too, adding to worries that the crisis could spread there. Italian banks held 295 billion euros of domestic government bonds at the end of April, up sharply from 210 billion euros at the end of December.

 

 

PILING ON THE PROBLEMS

With yields on Spanish sovereign bonds hitting 7 percent on Thursday - a borrowing cost widely seen as unaffordable - the dependence on local banks for funding is likely to increase.

Spanish banks will have to find an extra 11 billion euros to finance the government for the rest of 2012 if foreign investors stay away, analysts at Credit Suisse said.

Many already are. Non-Spanish residents held 38.1 percent of Spanish sovereign debt in April, down from 51.5 percent in December last year.

Spain's weakest banks which are laden with bad real estate debts - the prime targets for the European aid - are the most exposed to the sovereign troubles.

Spanish sovereign debt holdings of five nationalised lenders rose by 80 percent last year, a Bank of Spain report showed. It is almost certain to show another sharp rise this year when it includes Bankia, which needed a 19 billion euro state rescue last month and has 29 billion euros' worth of Spanish sovereign paper.

The relationship between state and banks may weaken any incentive governments have to let lenders fail, one of the few "circuit-breaker" ideas suggested to sever the loop between banks and sovereigns.

A lesson from Greece is that a two-pronged plan may be one of few options. "You would need to simultaneously recapitalise the banks and ensure sovereign competitiveness again, which is difficult within the structure of the euro," said Andrew Lim, a banking analyst at Espirito Santo Investment Bank.

Spain has so far resisted the idea of a full sovereign bailout, a fate which Prime Minister Mariano Rajoy said he had avoided by negotiating the bank rescue deal with the eurozone.

But worries about the Spanish budget deficit and overspending by its autonomous regional governments are still rocking markets, and these doubts will also deepen the immediate problems faced by the banks.

They are already facing steep demands to raise their capital to counter losses on real estate assets, which could end up reaching up to 70 billion euros.

© 2014 Thomson/Reuters. All rights reserved.

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