28/10/2014: Page 75... ECB Washes Out Its Big Bazooka QE with New NPLs...

In the previous (lengthy) post I covered my view of the ECB stress tests results. But, per chance, you have missed two core points on these, here they are, in a neater summary:

Point 1: Stress tests are weak compared to expectations and independent analysts' estimates of capital shortfall (by a factor of up to or in excess of10:1).

Point 2: Stress tests have raised non-performing loans levels in the euro area banking system by EUR136 billion to EUR879.1 billion or close to 9% of the euro area GDP. The increases were recorded in all categories of loans, which in simple terms means the banks have been under-providing for loans losses across all categories of their core assets.

Now, that puts into perspective the ECB's 'big game all-in' shot for TLTROs and ABS purchases targeting to raise ECB balancesheet exposures by... you've guessed it... EUR1 trillion.

Why, despite improving asset markets, stoic rhetoric of deleveraging and historically low cost of central banks' funds, the NPLs are climbing... and by the end of the ECB's big bazooka firing, that EUR1 trillion is probably will be just about enough to cover the outstanding NPLs. Assuming economy does not tank any more, in which case, it might fall short.


Update: Here's WSJ Blogs analysis of the effects application of the tougher quality tests for Core Tier 1 capital would have had on ECB stress test results: http://blogs.wsj.com/moneybeat/2014/10/27/tough-new-rules-would-have-caused-ten-more-stress-test-fails/

26/10/2014: Mind the ECB 'Stress Tests' Gap

The pain of European economy's Japanification is going to be proportionate to the cheering of the ECB 'stress tests' results.

The real problem faced by European economy is that of the depressed domestic demand (investment and consumption). This problem is fuelled by:
1) declining real incomes of those working,
2) continued sky-high numbers of those who are not working (unemployed, discouraged and never-once-employed workers left out in the cold),
3) growing unease amongst older workers about the state of their pensions,
4) rising burden of the state (including state debts),
5) growing pressure of redistribution of income from households and SMEs to politically favoured white elephant projects (e.g. renewables subsidies, large infrastructure spending, farm supports, regional integration etc),
6) un-abating waste at the EU and national levels anchored to corporatist politics selectively rewarding specific interest groups interests at the expense of entrepreneurs, younger workers, ordinary households and domestic firms, and
7) demographic collapse spreading across the continent as populations age and children remain dependent on ever older parents to support their education and transitioning into joblessness.

This real problem is driving down domestic demand, and with it depressing economy, but also spreading rot across the banks balance sheets.

And yet, despite the obvious and ever-deepening macroeconomic crisis of depressed demand, the ECB stress tests released today provide no insight into what can happen to the banks balance sheets should Japanification set in. Worse, the entire exercise of 'stress tests' is once again not much more than a PR stunt dreamed up by the folks who are 'would be' chief economists for the sell-side equity research.


Here's why.

Back in January 2014, two academics published a preliminary assessment of the Euro area banking union capital shortfalls: http://www.voxeu.org/article/what-asset-quality-review-likely-find-independent-evidence.

This identified stressed shortfalls estimated at between €82 billion and €176 billion (4% benchmark capital ratio) and €509 billion to €767 billion (7% capital ratio) based on book capital.  Take the average to compare to ECB results: ca EUR295-470 billion. "The market capital shortfall estimates indicate a capital shortfall of €230 billion (4% benchmark capital ratio) or €620 billion (7% capital ratio) for the 41 publicly listed banks". Take the average to compare to ECB results: EUR425 billion.

Worse, "estimates of SRISK or the capital shortfall in a systemic financial crisis (40% market decline over a six-month period) is €579 billion; 41% is due to downside correlation with the market, while 59% is due to the leverage of these institutions." So compare to 20% decline under ECB tests (across property assets, 30% decline) and get roughly half of the above figure at EUR290 billion.

Ugly? Try next: "Capital shortfall estimates when writing down their net non-performing loan portfolios range from €232 billion (using the C Tier 1 ratio and an 8% threshold as in the AQR) and €435 billion (using the tangible equity/tangible assets ratio and a 4% threshold)." Again, average these out at EUR330 billion or so.

And get this: "There is a high rank correlation between the shortfalls based on book and market capital ratio measures [but] no significant correlation between shortfalls calculated using regulatory (i.e. risk-weighted asset-based) capital ratios and shortfalls calculated under market or book capital ratios… this highlights how flawed risk-weighted asset-based measures can be."

Take the conclusion in with a deep breath: "Cross-country variation in our capital shortfall estimates indicate that:

• French banks are leading each book and market capital shortfall measure, both in absolute euro amounts and relative to national GDP. The capital shortfall ranges from €31 billion (using the equity/asset ratio and a 4% threshold) to €285 billion (using the tangible equity/tangible asset ratio and a 7% threshold). The SRISK stress scenario suggests a shortfall of €222 billion, which corresponds to almost 13% of the country’s GDP.
• German banks are close seconds, although they benefit from a stronger domestic economy with a higher GDP and a greater capacity for public backstops.
• Spanish and Italian banks appear to have large capital shortfalls when non-performing assets are fully written down. Both countries account for about a third of the total shortfall after write-downs. Market-based measures such as SRISK amount to about 6.5%–7.6% of the GDP of both countries."

So a close common value for estimated shortfalls, comparable to the ECB tests is around EUR290 billion for 41 listed banks (not 150 tested by EBA/ECB).

Oh dear, now think ECB stress tests: The ECB stress tests found virtually none of the above problems to be present or pressing (see full release here: http://www.ecb.europa.eu/pub/pdf/other/aggregatereportonthecomprehensiveassessment201410.en.pdf?d2f05d43d177c25c57e065ebdbf80fe7). Instead, the ECB tests estimated shortfall in the banks to be EUR24.6 billion as of December 2013 and that all but EUR9.5 billion of this has been already rectified by the banks.

This is plain mad not only because it is more than 10 times the number averaged out above, but also because the same ECB review found that some EUR136 billion of loans held by the banks as assets should be classed as non-performing. That is an 18 percent hike in one sweeping year. 85% of banks tested had to revise up their bad loans exposures. And this implies that EUR47.5 billion worth of losses is required to bring these 'assets' in line with their true values.

These losses will have to be covered from either more tightening of existent loans costs or via capital raising or by shrinking returns on equity or all of the above. And these losses are at the lower (as noted by independent analysts) end of the range. And these losses are going to impact future capital access by the banks too, as who on earth would want to stake a house on investing in sick banks hiding the true extent of their losses to the tune of 18 percent?!

All in, Euro area banks now have a hole of EUR879 billion in non-performing loans, facing losses of some EUR300 billion, plus. Based on already stretched (by extend-and-pretend measures adopted to-date) loss rate on non-performing assets. Oh, dear…

Table below summarises sources of NPL increases by category of assets:

As of the end of 2013, per ECB own assessment, some 1/5 of all major banks were in the position of facing high risk of going bust. Forward nine months into this year - what has changed? Nothing, save for the following factors:

1. ECB funding became temporarily cheaper (rates down), but LTROs are being replace by higher priced TLTROs and this means cost of funding going slightly up;
2. Assets valuations have improved on massive monetary stimuli. These being gradually reduced (outside the euro area) is going to depress carry trades that have been helping asset prices boom. Asset values might not fall, but realising these values in the markets forward and counting on their further significant appreciation would be equivalent to taking serious risks.
3. Real economic conditions have deteriorated. Which is far from being trivial, as in the long run, asset values and availability and cost of funding should start reflecting this reality. Once they start, there'll be pain on balance sheets. 

What are the safety cushions post-ECB tests? Ugh, rather thin. Of 130 banks tested by the ECB, 25 failed, 31 had core capital ratio below 10% - the safety threshold accepted in the markets. 28 more banks were within a 10-11 percent range. Thus, 84 out of 130 banks tested were either in an ICU or on ventilators.

Looking back at the main findings from January 2014 paper by Viral Acharya and Sascha Steffen, what is striking is the position of the German and French banks. ECB found virtually no problems in both countries banking systems (see Table below):

Table: Banks that failed ECB tests

Look at geographic distribution of losses under stressed scenario:

Setting aside the proverbial 'periphery' (and Slovenia) there are virtually no problems in the stress case across the national banking system anywhere, save for Belgium, the Netherlands, and Luxembourg. Even Italian system is within 1 percentage point of the median losses. You have to be laughing, right?

And the above only holds for 57% of all assets of the tested banks. That's right, the AQR exercise did not cover all assets held by the 130 banks tested.

Meanwhile, macroeconomic risks factored in are rapidly becoming not stringent enough. The ECB tests were based on EU Commission forecasts from Q1 2014. Since then, the forecasts have seen consistent downward revisions. Instead of focusing on the risk of deflationary recession and stagnation (Japanification), the risks tested were based on bond markets stress, plus recession.

There is virtually no material deterioration in ECB assessment results for German banks compared to previous tests. How? We can only scratch our heads. In the last 2 years, German economy has gone from moderate growth to slow growth and is heading into stagnant growth.

Emerging markets risks exposures were non-existent in the view of the ECB tests, except via higher interest rates impact spillover from the US (assumed by the ECB). Neither were the risks arising from the global slowdown in trade flows. So here's a kicker, if rates are higher and there is a global slowdown, impact on banks balance sheets will be most likely lower than if rates are low (and with them lending margins), but there is a secular long term growth crisis in the euro area itself. Second order effects will be smaller than first order effects.

All in, the 'stringent' tests carried by EBA and ECB took 150 banks and banks subsidiaries and found that 25 of these were short of EUR24.6 billion in capital: 16.7% of banks failed, average capital requirement per failed bank EUR984 million, average capital required per all banks tested: EUR164 million. Contrast this with 2011 when EBA tested 90 banks, failed 20 of these (failure rate of 22.2% much higher than 16.7% in this round of tests), requiring them to raise EUR26.8 billion in capital which amounts to EUR1.34 billion per failed bank (much higher than ECB stress tests this time around) and EUR298 million per bank tested (much higher than ECB tests). Yet, 2011 tests were labeled a farce by the markets.

Today's tests are no better. If not worse.

Worse because they fail to account for the real risks arising in the Euro area today and worse because they create a false sense of security within the system. Or maybe they do not. In which case the entire exercise is a PR stunt, with ECB having a different and more descriptive picture of what is really happening in the banking sector. Maybe so… in which case, does the whole charade qualify as market manipulation by the soon-to-be super regulators? Take your pick, either the regulators-to-be are wearing rose-tinted glasses, or they are fixing the market. Neither is a pretty option...

11/12/2013: Will Europe Have Any Firepower for Banks Bail Outs?

The Banking Union debate drags on and on and on and the further we travel in time into this debate, the more apparent is the pathetic nature of the undertaking, and with it, the pathetic state of leadership across Europe... Here's the latest instalment:
http://blogs.ft.com/brusselsblog/2013/12/eu-bank-bailout-fight-more-leaked-documents/

Key quotes in this latest instalment:

"Both the European Commission and the European Central Bank – along with most eurozone finance ministries – believe a “break in case of emergency” backstop needs to be in place to provide a safety net for the bank rescue fund since, even when it’s completely full, it will only have €55bn in it. Given the recent crisis experience, that might only be enough to bail out two or three mid-sized European banks."

Laugh! or Cry! or both. The entire circus is about EUR55 billion. Not enough to backstop another Ireland (based on the 2008-2010 crisis dimensions). Not enough to backstop the retail division of the Deutsche Bank alone (based on 5% loss over capital cushion). Not enough to backstop anything, really. Administration, compliance, enforcement and other bureaucratic functions associated with this backstop (and the necessary Banking Union spoking it to the ECB and the eurosystem) will be running at somewhere around 5-10 percent of the entire fund, annually. If this is a form of insurance, you might getter better quote on insuring Titanic in its current state for passenger traffic.

"In addition, the fund will take 10 years to completely fill through levees on European banks, meaning some kind of backstop needs to be in place in the interim. The “SRF Backstop” paper basically says: we need a backstop, but we’re still not sure what it should be or how it would work."

Two things. Unless euro area hopes to remain in the Great Stagnation for the next 10 years, we shall see growth in banks balancesheets. Over 10 years horizon (even if balancesheets grow at 1.5% = real GDP growth expectation for euro area + HICP target, so 3.5% nominal growth pa in balancesheets), the banking assets side (covered liabilities from the SRF perspective) will have expanded by 41 percent. In other words, to provide the same cover as today's EUR 55 billion the fund will require EUR 78 billion. Forget the idea that in its current vision SFR will only be sufficient to bailout two or three mid-sized European banks. We'll be lucky if it can bailout 1 or 2 of mid-sized European banks in 10 years time.

24/2/2013: EU's Banking Union Plan Can Amplify Moral Hazard It Is Designed to Cure

In a recent note, Germany's Ifo Institute (Viewpoint No. 143 The eurozone’s banking union is deeply flawed February 15, 2013) thoroughly debunked the idea that the European Banking Union is a necessary or sufficient condition for addressing the problem of moral hazard, relating to the future bailouts.

Per note (emphasis is mine), "Largely ignored by public opinion, the European Commission has drafted a new directive on bank resolution which creates the legal basis for future bank bailouts in the EU. While paying lip service to the principle of shareholder liability and creditor burden-sharing, the current draft falls woefully short of protecting European taxpayers and might cost them hundreds of billions of euros."

Instead of directly tackling the mechanism for bailing-in equity and bondholders in future banking crises, "the new banking union plans may... turn out to be another large step towards the transfer of distressed private debt on to public balance sheets..."

Here's the state of play in the euro area banking sector per Ifo: ECB "has already provided extra refinancing credit to the tune of EUR 900 billion to commercial banks in countries worst hit during the crisis... These banks have in turn provided the ECB with low-quality collateral with arguably insufficient risk deductions. The ECB is now ...guaranteeing the survival of banks loaded with toxic real estate loans and government credit. So the tranquillity is artificial."

I wholly agree. And worse, by doing so, the ECB has distorted competition and permanently damaged the process of orderly winding down of insolvent business institutions, as well as disrupted the process of recovery in terms of banking customers' expectations of the future system performance. Per Ifo, "Ultimately, the ECB undermines the allocative function of the capital market by shifting the liability from market agents to governments."

The hope - all along during the crisis - was always that although the present measures are deeply regressive, once the current crisis abates and is reduced from systemic to idiosyncratic, "the European Stability Mechanism (the eurozone’s rescue fund – ESM) and the banking union plan [will impose] more [burden sharing of the costs of future crises on] private creditors".

The problem, according to Ifo is that neither plan goes "anywhere near far enough" to achieve this. "..the “bail-in” proposals suggested by the European Commission as part of a common bank resolution framework [per original claims] “should maximise the value of the creditors’ claims, improve market certainty and reassure counterparties”".

Nothing of the sorts. Per Ifo: "Senior creditor bail-ins are explicitly ruled out until 1 January 2018, “in order to reassure investors”. But if bank creditors are to be protected against the risk of a bail-in, somebody else has to bear the excess loss. This will be the European taxpayer, standing behind the ESM."

"The losses to be covered could be huge. The total debt of banks located in the six countries most damaged by the crisis amounts to EUR 9,400 billion. The combined government debt of these countries stands at EUR 3,500 billion. Even a relatively small fraction of this bank debt would be huge compared to the ESM’s loss-bearing capacity."

Ifo see this four core flaws in "institutional architecture" of the bail-in mechanism:

• "First, the write-off losses imposed on taxpayers would destabilise the sound countries. The proposal for bank resolution is not a firewall but a “fire channel” that will enable the flames of the debt crisis to burn through to the rest of European government budgets." 
• "Second, imposing further burdens on taxpayers will stoke existing resentments. Strife between creditors and debtors is usually resolved by civil law. The EU is now proposing to elevate private problems between creditors and debtors to a state level, making them part of a public debate between countries. This will undermine the European consensus and replicate the negative experiences the US had with its early debt mutualisation schemes." 
• "Third, asset ownership in bank equity and bank debt tends to be extremely concentrated among the richest households in every country. Not bailing-in these households’ amounts to a gigantic negative wealth tax to the benefit of wealthy individuals worldwide, at the expense of Europe’s taxpayers, social transfer recipients and pensioners."
• "Fourth, the public guarantees will artificially reduce the financing costs for banks. This not only maintains a bloated banking sector but also perpetuates the overly risky activities of these banks. Such a misallocation of capital will slow the recovery and long-run growth."

Note that per fourth point, the EU plans, while intended to address the problem of moral hazard caused by current bailouts, are actually likely to amplify the moral hazard. In brief, "...the proposal for European bank resolution exceeds our worst fears."

Note that the Ifo analysis also exposes the inadequacy of the centralisation-focused approach to regulation that is being put forward as another core pillar of crisis prevention. "A centralised supervision and resolution authority is necessary to address the European banking crisis. But that authority does not need money to carry out its functions. Instead bank resolution should be subject to binding rules for shareholder wipeout and creditor bail-ins if a decline in the market value of a bank’s assets consumes the equity capital or more. If the banking and creditor lobbies are allowed to prevail and the commission proposal passes the European parliament without substantial revision, Europe’s taxpayers and citizens will face an even bigger mountain of public debt – and a decade of economic decline."

I couldn't have said it better myself.

18/10/2012: Summit/Dinner+Dinner Commencing

With the start of the 2-day summit (cross-out: series of dinners) at the EU, here's what JPM research team we should expect from the meetings:

In brief: expect nothing much... With that, may I wish good 'news hunting' for the army of media folks besieging EU buildings...