Symp­toms of dys­func­tion

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

If bank shares are the ca­nary in the global eco­nomic coalmine, they are cur­rently singing a very alarm­ing tune. In Ja­pan bank shares have cratered -10% since last Fri­day’s de­ci­sion by the cen­tral bank to move to neg­a­tive in­ter­est rates, even though the new neg­a­tive -0.1% rate will only ap­ply on the mar­gin to ad­di­tional de­posits at the Bank of Ja­pan.

Else­where, in Europe, the bank­ing com­po­nent of the Euro Stoxx in­dex has slumped -16.8% year-to-date, while the broader in­dex is down a “mere” -6.8%. Sim­i­larly, in the US, bank shares are down -11.9% YTD, com­pared with the S&P 500, which is down some -5%.

In part, this un­der­per­for­mance re­flects mar­ket fears about what may be lurk­ing on bank bal­ance sheets; Ja­pan’s mega­banks, for ex­am­ple, have sig­nif­i­cant ex­po­sure to oil pro­duc­ers. But in a broader sense, the slump in bank shares is symp­to­matic of per­sis­tent dys­func­tion in the sec­tor. Seven and a half years af­ter the global fi­nan­cial cri­sis (and quar­ter of a cen­tury af­ter the burst­ing of Ja­pan’s bub­ble econ­omy), ef­forts to clean up and strengthen bank bal­ance sheets have fallen far short of what is needed to cre­ate healthy and re­silient bank­ing sec­tors. Worse, the sense is grow­ing that when it comes to bank­ing sec­tor sta­bil­ity, the tools adopted by cen­tral banks to pump up in­fla­tion and re­vi­talise eco­nomic growth — ul­tra-low and even neg­a­tive in­ter­est rates across much of the curve — are do­ing more harm than good.

For a pic­ture of bank­ing dys­func­tion, in­vestors need look no fur­ther than Europe. De­spite much-vaunted plans for “a fully-fledged bank­ing union”, prob­lems abound. The big­gest is ar­guably the weak­ness of Italy’s bank­ing sec­tor. Last week, the Ital­ian govern­ment agreed a plan to help Italy’s banks dis­pose of the EUR 350 bln in non-per­form­ing loans — equiv­a­lent to 22% of gross do­mes­tic prod­uct — they are car­ry­ing on their bal­ance sheets. We doubt it will work.

Un­der new EU rules which pro­hibit di­rect state aid to the bank­ing sec­tor, Rome can­not copy the for­mula adopted by Spain and Ire­land, and move non-per­form­ing as­sets off bank bal­ance sheets and into a state-backed “bad bank”. The govern­ment’s so­lu­tion, agreed af­ter months of ne­go­ti­a­tion, is to of­fer a guar­an­tee mech­a­nism it hopes will en­cour­age pri­vate in­vestors to buy se­cu­ri­tised NPLs.

Un­der the new scheme, banks will bun­dle their bad loans into se­cu­ri­ties so that the se­nior tranche of each is­sue — the first to be re­paid out of pro­ceeds re­cov­ered from the un­der­ly­ing as­sets — is of suf­fi­ciently high qual­ity to achieve an in­vest­ment grade credit rat­ing. The govern­ment will then guar­an­tee this se­nior tranche (and only this tranche). To cir­cum­vent the rules against state aid, is­su­ing banks will have to pay a reg­u­lar fee to the govern­ment for its guar­an­tee. The fee will be priced off bench­mark credit de­fault swaps for ref­er­ence cred­its of sim­i­lar qual­ity, and will be re­set up­wards over time to en­cour­age a speedy re­cov­ery process.

By of­fer­ing a guar­an­tee, the govern­ment hopes to bump up the mar­ket value of the un­der­ly­ing loans more closely into line with the value at which they are car­ried on the banks’ books, min­imis­ing bank losses, while si­mul­ta­ne­ously en­cour­ag­ing in­vestors to buy the bonds, so cre­at­ing a new mar­ket for dis­tressed debt. How­ever, be­cause of the EU’s new re­stric­tions on state aid, the Ital­ian deal falls far short of the Span­ish and Ir­ish res­o­lu­tion schemes, un­der which large tranches of NPLs were trans­ferred into “bad banks”, free­ing up the “good banks” to re­struc­ture and re­sume lend­ing. In both Spain and Ire­land, banks were forced to par­tic­i­pate in the re­struc­tur­ing pro­grammes. Un­der Italy’s plan each in­di­vid­ual bank will de­cide whether to pay for the govern­ment guar­an­tee and ac­cept a write­down in as­set val­ues, or al­ter­na­tively to leave the bad as­sets on its bal­ance sheet.

Even in Spain and Ire­lan,d NPLs re­main painfully el­e­vated at 10% and 20%, re­spec­tively, sup­press­ing new credit cre­ation. So, it looks un­likely that Italy’s new plan will cut NPL lev­els by any­thing like enough to make an ap­pre­cia­ble dif­fer­ence to banks’ will­ing­ness to ex­tend new loans. As a re­sult, bank­ing sec­tor prof­its will con­tinue to un­der­per­form, while Italy’s econ­omy will re­main hand­i­capped by weak credit cre­ation and in­vest­ment. Worse, com­pa­nies with un­re­solved debt prob­lems will be un­able to ham­per­ing the process of cre­ative de­struc­tion.

The govern­ment is promis­ing to pub­lish fur­ther de­tails of its guar­an­tee mech­a­nism soon, which may as­suage some of our doubts. How­ever, as things stand now, much of the Ital­ian bank­ing sys­tem re­mains dys­func­tional, call­ing into ques­tion the abil­ity of the EU’s pro­posed bank­ing union to de­liver a strong, healthy and in­te­grated bank­ing sys­tem for the Euro­pean con­ti­nent. Judg­ing by the re­cent price ac­tion in global mar­kets, things are scarcely any bet­ter else­where.


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