The market reaction to the recent Asset Quality Review (AQR) and Stress Test (collectively referred to as the Comprehensive Assessment) was fairly sanguine in respect of the overall result. The AQR lowered end 2013 asset carrying values by €48 billion. Non-performing exposures were increased by €136 billion.
The stress test catered for two hypothetical scenarios: the baseline and adverse. Banks are required to maintain a Common Equity Tier 1 (CET1) ratio of at least eight per cent and 5.5 per cent respectively. In the adverse scenario, the aggregate capital is projected to be reduced by €216 billion by 2016. This represents 22 per cent of the total capital held.
Overall, 25 banks were projected to have a capital shortfall of €25 billion. Nine of those are Italian, including the world’s oldest bank – Monte dei Paschi Di Siena, established in 1472.
Malta’s two major banks, Bank of Valletta and HSBC (Malta), performed well, although there are some interesting differentials between the two, which merit future discussion.
The received wisdom is that if a bank has passed the comprehensive assessment, as most banks did, then it is essentially in a position to extend credit. This conclusion may be correct, and it certainly is in the case of our local major banks, but of course that does not mean that the credit will actually be extended. Passing the Comprehensive Assessment was a pre-requisite to allow for the potential – but it is not sufficient to guarantee the result.
The reasons for that can generally be placed in two simple categories:
The banks may be able, but unwilling, to lend. That is a supply issue.
The banks may be able and willing to lend, but there is no appetite to take on credit. That is a demand issue.
Supply side constraints include scenarios where banks take a pessimistic view on the outlook for the economy, with consequent rising potential for non-performing loans.
Another constraint is the crowding-out effect exerted by government, in the form of sovereign debt. Sovereign debt has the technical advantage of being liquid. It is also less capital intensive, since it is subject to a zero risk weight in the risk weighting methodology.
If it is also seen as actually being risk free from a commercial perspective, wrongly or rightly, then it becomes almost surprising that there is any lending at all. This is especially so if all the regulatory signals encourage risk aversion, the regulatory scrutiny pertains to capital adequacy, and stress tests favour sovereign debt relative to other asset classes.
There is a more subtle point: in the first instance, it is not immediately clear why society even needs an intermediation process between itself and its own government for the funding of the State.
There is also a related issue. Deposits are the lifeblood of a typical bank’s (I exclude banks reliant on the wholesale market for funding) ability to fund assets, which include sovereign debt holdings. Since deposits must be seen as risk free, some form of depositor compensation scheme is generally deemed necessary. The current system of wholly guaranteeing qualifying deposits (as opposed to guaranteeing 95 per cent of qualifying deposits for example, in order to introduce an element of self interest), only serves to attract them indiscriminately.
On the flip side, banks can also proactively attract deposits with a view to redeploying them in the sovereign debt market. The net effect is that systemic risk increases, profits are privatised, but the risks are socialised.
Demand side constraints transpire when potential borrowers feel that the economic environment is too hostile to operate in. A policy of austerity, as favoured by Brussels, ensures such an environment. In simple terms, if you destroy disposable income, you destroy demand. If you destroy demand, you destroy the means to repay the credit.
Another demand constraint is that an increasing number of enterprises are simply less capital intensive than before.
Demand is also constrained if the cost of credit is simply too high. While ECB rates have dramatically declined, bank lending rates have declined less dramatically.
Let us recall that the effectiveness of the ECB’s actions is ultimately subject to policy decisions being made both at the EU and national levels. Some of these decisions are motivated by what is best for the ‘eurozone economy’. However, the eurozone economy is a composite and what is good for one nation’s economy is not necessarily good for another’s – at least in the short run. An example would be German insistence on austerity measures, and peripherals fighting for expansionary policies.
Other decisions are motivated by political expediency and idealism. An example of this would be the dogmatic, unquestioned assumption that the euro is the most appropriate tool to serve the interests of all of the eurozone’s population.
The outcome is plain to see – a chronically weak economy, with high unemployment, which is being thoroughly outpaced by the economies of Western peers such as the US.
One of the criticisms that can be levelled at the Comprehensive Assessment is that, even in the hypothetical adverse scenario, a deflationary environment is not contemplated. And yet, that is the very thing the markets are concerned about. One of the strongest arguments in support of the peripherals surely is the fact that the ECB has manifestly failed in its objective to generate anywhere near two per cent inflation. That failure has placed an undue burden on their debt servicing obligations. Nevertheless, even though the ECB did not fulfil its part of the bargain, the mantra remains that the peripherals must (asymmetrically) ‘stick to the rules’.
It is perhaps surprising that the credit markets have not paid more attention to this issue, since it strikes at the heart of debt sustainability in the eurozone.
Inspired thinking appears lacking in Brussels. Instead we are more likely to get ‘dead horse’ type solutions
Political posturing, jawboning of the markets and kicking the can down the road can only perpetuate the charade for so long. The mathematics are inescapable and brutally simple, as Barry Eichengreen recently articulated neatly in the Financial Times.
The Commission’s objective is for debt/GDP ratios to be brought down to 60 per cent by 2030. To achieve that, one has to make what are surely unrealistic assumptions in respect of primary budget surpluses. For example, Eichengreen argues that the average annual primary surplus for the period 2020-2030 is likely to have to exceed four per cent for Spain, and five per cent for Ireland, Italy and Portugal. It is noted that since the mid-1970s there have been only three countries (Norway, Singapore and Belgium) that managed five per cent surpluses for 10 years, and all three were exceptional cases.
This leads to the inevitable conclusion that there are only two likely eventual outcomes.
The first option is debt restructuring – effectively a default, not to put too fine a point on it.
Note that the AQR treats sovereign debt as risk free. The very concept of attaching a zero risk weight to any asset is fundamentally flawed – it allows a bank to run up huge exposures subject only to liquidity, not capital, constraints. Thankfully, the stress test does not treat sovereign debt as risk free and this treatment will effectively impose capital constraints.
This option appears to be politically unacceptable. However, one can speculate that the political acceptance might increase if it is considered that the banks themselves could withstand the loss – and the stress test is of particular interest in this respect. Investors sometimes have short memories, but they should recall that the inability of the banks to withstand losses was cited as one of the reasons why Greece could not be allowed to default.
The second option is to grow the economy, such that the debt/GDP ratio declines. As discussed, the current mindset is to stick to the rules and perpetuate the austerity regime, with all its negative consequences.
There are other, more radical solutions aimed at long-term sustainability. To be effective, these would have to identify and address the root causes of the malaise. These include growing inequality, globalisation, automation, changing demographics and intra-generational distributions. They involve governments understanding the need to add value when they add debt, and not simply treating short-term Keynesian fixes as permanent solutions.
They involve revisiting the scope of banks and their interdependency with the sovereign. In the eurozone, it involves a candid assessment of whether the euro represents an economic (not political) benefit, or an economic cost.
But all of this requires the kind of inspired thinking that appears so lacking in Brussels. Instead, we are more likely to get ‘dead horse’ type solutions – stronger whips, changing personnel, committees, solemn declarations, additional funding, bridges to nowhere, lowering of hurdles, abandonment of principles and the grouping of dead horses in the name of solidarity. Sometimes it is simply better to change horse.
This dysfunctional behaviour will lead, is leading, to sub-optimal outcomes. It represents a formidable obstacle to the ECB’s aspirations, and a threat to the prosperity of the eurozone’s population.
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Martin Webster is the head of equity research at Curmi & Partners Ltd.