28/3/2013: Cyprus: too-small-to-fail, too-small-to-bail

This is an unedited version of my article for Sunday Times, March 24.


This week, euro area leaders have added yet another term to the already rich vocabulary engendered by the financial crisis. If only a few days ago the world was divided into too-big-to-fail (e.g. Irish pillar banks and Spain) and too-big-to-bail (e.g. Italy) institutions and economies, today we also have too-small-to-fail and too-small-to-bail economy, Cyprus.

Worth just 0.2% of the euro area GDP, with the insolvent banking sector and the liquidity strained sovereign, Cyprus is a tiny minnow in terms of both the required external assistance and its direct impact on the euro area economy. The country overall GDP amounts to about ½ of the cost of bailing out Anglo Irish Bank, and its banking and fiscal troubles need just EUR15.8 billion of funding to plug the gap left by the EU mishandling of the Greek bailout back in 2011-2012. With the reputational costs to the euro area of letting this nation go into an unassisted default, Cyprus is simply too-small-to-fail.

Despite this, the end game now being played in Nicosia, Moscow, Frankfurt and Berlin shows that Cyprus, perhaps, is also too-small-to-bail. The problem is that granting sufficient funding to Cyprus via Troika loans risks pushing the Cypriot Government debt/GDP ratio to 170% even with the haircut on depositors. Were the EU adhere to the conditions of the bailout that also envision Cypriot banking and financial services sectors shrinking to euro area average in size, the government debt to GDP ratio can reach above 210 percent. Yet, altering the terms of the bailout to provide funds that are not debt-based, such as directly funding the banks writedowns of Greek Government bonds, risks triggering calls for similar actions across the rest of the euro area periphery. Pretty quickly, Cypriot EUR10 billion bill can swell to EUR200-250 billion call on the ECB.

These dilemmas, yet to be fully articulated by the policymakers publicly, are nonetheless informing the mess behind the recent events. In the view of euro area leadership, dealing with Cyprus either requires bankrupting its economy and its people, or risking destroying the monetary system infrastructure that rests on the ECB’s pursuit of singular, deeply flawed, yet legally unalterable mandate. A familiar conundrum that has been played out in Ireland, Greece, Portugal and Spain by the incompetent crisis management from Brussels, Frankfurt and Berlin.

Alas, what is still missing in the Cypriot Dilemma debates is the consideration of the longer-term impact of this latest iteration in the euro area crisis on broader European economy.

In this context, Cyprus is neither too-small-to-bail, nor too-small-to-fail. Instead, it is a systemically important focal point of the euro area financial crisis.

The Cypriot crisis orderly resolution requires funding from some non-debt sources to plug the gap between EUR17 billion in funds needed and EUR10 billion that can be committed in the form of loans. The EU has opted to bridge this gap with a levy on the deposits, thus triggering a wholesale expropriation of private property without any legal basis for doing so.  This expropriation, termed in the language resembling Orwell’s “1984” “an upfront one-off stability levy”, also cuts through the allegedly inviolable State Guarantee on all deposits under EUR100,000.

As the result, since last weekend all European and foreign depositors in the EU banks are no longer treated either pari passu or senior to risk investors, such as bondholders, but subordinated to them. Safety of deposits is no longer assured by the banking system or by the Sovereign guarantees. One of the cornerstones of the yet-to-be-established European Banking Union - the joint system of deposits insurance protection – is no more a credible mechanism of protection of ordinary savers.

In the short run, as highlighted in the media during the week, this means potential for bank runs in Greece (where depositors are already facing substantial potential losses through their savings in Cypriot banks and the state finances are in a much worse state than they are in Cyprus), Spain (with the Government desperate to fund its fiscal adjustments amidst rising tide of discontent with austerity measures) or even Italy (where savings in form of bank deposits are the main pillar of pensions provision for the aging population). In Cyprus itself, the debacle of the European leadership crisis management approach is now leading to the growing risk of the country being forced to exit the euro area.

In my view, these are low probability, but high impact risks that must be considered simply for the devastating effect they would have on the rest of the euro system.

Even if the above short-term nightmare scenarios do not play out, the Cypriot Dilemma is not going away.

Throughout the crisis, the EU has adopted a ‘muddle-through’ approach to dealing with the problems. This has meant that instead of using aggressive monetary policy, as the US and the UK, in addressing the crisis, the EU used debt tools to plug the financing gaps in the banking and fiscal sectors. The result of this was a dramatic uplift in overall debt burdens.  While euro area General Government deficit is expected to reach a relatively benign 2.56% in 2013 with a primary balance (excluding debt financing costs) forecast to post a surplus of 0.25%, close to the pre-crisis 2008 levels, euro area government debt is expected to rise from 70% of GDP in 2008 to 95% this year. Deficits are down, debt is up, public and private investment and deleveraging running at negative or zero rates. These dynamics clearly show the true cost of the EU leadership crisis.

In the long run, Cyprus blunder is going to yield dramatic economic and social costs.

Firstly, any resolution of the Cypriot crisis will involve unsustainable debt for the Government and the wholesale destruction of the Cypriot economy. With EU-demanded scaling back of the banking sector on the island to the ‘euro area average’, Nicosia is facing an outright contraction in the nation GDP of some 15-17% on pre-crisis levels. Second-order effects of this measure and the increase in the island corporation tax rate also demanded by Brussels will take economic losses closer to a quarter of the national income. There are no potential sources for plugging this economic hole. Even the promises of the off-shore gas reserves will not deliver economic recovery to the society with effectively no oil and gas expertise, skills or firms present in the economy.

The EU is de facto sealing the fate of one of its members as the second-class state within the Union just as it did with the rest of the ‘periphery’.

Long-term impact of debt accumulation as the sole mechanism for dealing with the crisis will also hit the entire euro area.  Per IMF relatively benign projections, euro area combined debt to GDP ratio will now exceed or equal 90% bound for at least six years in a row. This means that the euro area is facing a debt overhang crisis of the size where Government debt levels impose a long-term drag on overall economic growth. Any adverse headwinds to economic growth and fiscal performance in years to come will have to be faced without a cushion allowing for fiscal policy accommodation.

Undermining of the sovereign guarantees and depositors’ protection principles in the Cypriot case, even if reversed in the final agreement, will also have a long-term effect on euro area growth potential. With savings no longer secured from expropriation, euro area is facing long-term realignment of the household investment portfolios. This realignment will reduce bank deposits, especially the more stable termed deposits, and lower euro area assets held by the households. The end result will be higher cost of bank credit and equity in Europe, smaller supply of loanable and investable funds and, thus, lower long-term investment activity.

Violation of the property rights and trampling upon the principles of the common market in structuring of the original Cyprus ‘rescue’ plan means that overall risk-return valuations by investors will be re-adjusted to reflect the state of policymaking in Europe that puts bondholders over all other financial system participants, including, now, the depositors.

Currently, euro area economic activity and investment are funded primarily via bank credit, reliant on deposits and bank capital. Shares and equity account for around 14.3% of the total household portoflios in Europe as contrasted by 32.9% in the US. In order to rebalance the euro area investment markets away from reliance on more expensive and risk-prone bank lending, the EU must incentivize equity holdings over debt and shift more of the banks funding activity toward more stable deposits, reducing the amount of leverage allowed within the system.  Cypriot precedent makes structural change away from debt financing much harder to achieve.

Lastly, the Cypriot crisis has contributed to the continued process of deligitimisation of the EU authorities in the eyes of European people who witnessed an entirely new and ever more egregious level of the first-tier Europe (the so-called ‘core’) diktat over the social and economic policies in the peripheral state.

Prior to last week, Cyprus might have been too-small-to-fail or too-small-to-bail from Frankfurt’s or Berlin’s perspective, however the way the EU has dealt with this crisis exposes systemic flaws in the political economy of the euro area that cannot be easily repaired and will end up costing dearly to the entire EU economy.

Box-out: 
The revenue commissioners annual statistics data for 2011 throws some interesting comparisons. Back in 2010, prior to the more recent increases in income-related levies and charges, gross taxable personal income in Ireland amounted to EUR77.7 billion against the taxable corporate income of EUR70.8 billion. The amounts of income and corporate taxes paid on these were, respectively EUR9.82 billion and EUR4.25 billion, yielding effective economy-wide rates of tax of 12.6% for personal income and 6.0% for corporate tax. Thus, excluding USC, PRSI, most of Vat, and a host of other taxes and charges applicable uniquely to households, Irish Government policy is explicitly to tax personal income at an effective rate of more than twice the rate of corporate income. Of course, this disparity in taxation is inversely correlated with the disparity in representation: when was the last time you heard our leaders talk about not increasing tax burden on people as a sacrosanct principle of the state in the same way they talk about protecting our corporation tax regime?

25/3/2013: Cyprus is unique in its problem... oh, wait...

So you'd think Cyprus is the 'bad boy' in grossly-overweight-financial-services club? Oh... right:

Source

Now, wait, I am sure the Department of Spin is going to come after me pointing that 'Ireland's figures include IFSC'... my reply... so what? Cypriot figures include Sberbank & VTB... and, unlike the-best-in-the-class Ireland, Cyprus is just starting to deleverage its financial services sector.

25/3/2013: Cyprus 'deal' - notes from the impact crater

What are the true 'innovations' of the Cypriot 'bailout' deal?

1. At this junction one must face the realisation that European 'leadership' vacuum has reached alarming proportions. Cyprus was pushed to the brink, literally hours away from ELA cut-off, with a deliberate and mechanical precision. This is hardly consistent with any spirit of subsidiarity and/or cooperation that the EU was allegedly built on. In a further affirmation of the mess that is EU policy-making, the markets must now be aware that the EU has no defined approach to dealing with debtors and creditors, nor with issues of assets or liabilities. In other words, five years into the crisis and numerous 'white papers' later, with acronym soup of various 'solutions' and new 'institutions' thicker than pasta fagioli - there is still no clarity, no legal or institutional commitment, no formula, no predictability, but rather politically-motivated swinging from one extreme (no bail-ins in Ireland) to the other (all bailed-in in Cyprus).
2. We now have bailed in uninsured bank deposits within the so-called 'open' economy with 'common currency' and 'common market' based on rules and laws. In other words, unlike in Ireland, Portugal and Greece, the EU has crossed another line.
3. We now have bailed in senior bank bondholders (and the sky did not fall)
4. We now have capital controls within 'common currency' area and within the 'common market' - kind of equivalent to Louisiana declaring its dollars purely domestic to Louisiana. 
5. Bail-ins under the Cypriot deal are non-transparent and not defined, showing that the entire package was put together is a half-brained fashion at the last minute. Surely this, if not the first but very much the most exemplary indicator of the complete mess in policymaking. It further reinforces the view of PSI measures - both in Greece and in Cyprus - as being politically motivated, rather than systemically and legally structured.
6. The fact that the Cypriot banking system will now be completely shut out of the funding markets reinforces my view that unwinding the 'emergency' measures deployed by the ECB during the crisis will be: a) risky, b) costly and c) protracted. As the result, the monetary policy risks missing the window for optimal interest rates reaction and either over-reaching on the inflationary side or over-tightening to the detriment to future growth. either way, peripheral countries will be the likely victims.

Overall, from the EU-wide point of view, Cypriot 'deal':

• Does not reduce the risk of contagion or re-amplification of the crisis in other peripheral states;
• Does not create or even enable a break between sovereign and bank crises; 
• Adds to the overall quantum of policy uncertainty; 
• Raises even more doubts as to the functionality of the cornerstone crisis-related institutions (ESM and OMT); and
• Acts to strengthen the hand of eurosceptic, nationalist and populist political movements and parties in the Euro area 'periphery'.

25/3/2013: Debt, Demand & Deposits: Cyprus 2013

Der Spiegel has a handy graphic detailing the extent and the depth of the Financial Services sector in Cyprus...

[link]

The above lumps together couple of things that should, really, be addressed:

1. Cyprus' financing needs only cover banks recapitalisations to the deposits base as provided by the end-of-January 2013 figures. Since then at least EUR3-5 billion and more likely even more fled the country. And selection bias suggests that larger depositors (potentially with more political connections) were more likely to avail of 'systemic' exemptions to withdrawals in recent days.
2. As termed deposits mature, more will leave, unless the Government imposes involuntary lock-in for depositors with termed contracts.
3. Cyprus' financing needs above do not include non-CB and non-deposit funding for the banks that is going to mature in months to come and has to be replaced by some other source of funds (presumably we can assume that ECB / ELA will step in, but I don't see how that arrangement in the medium term can be pleasing to the ECB).
4. The deposits above do not break out MFI deposits, corporate deposits and personal deposits. It is one thing to bail-in personal accounts and yet altogether another matter to bail-in corporations and other banks (the former are subject to more strict capital controls than the latter two).

These are material risks to the sustainability of the Cypriot 'bailout' programme.

25/3/2013: Bankrupted Cyprus, aka 'The Rescue'

While European 'leaders' celebrate the breakthrough 'bailout' agreement with Cyprus, let's get back to Planet Reality, folks. The 'deal' is based on a EUR10bn loan to the Cypriot Government for which the taxpayers will be on the hook.

EUR10bn = 56.2% of the country 2013 forecast GDP.

And now, let's begin counting the proverbial chickens:

1. IMF forecast for GDP - used above - is based on nominal GDP growth over the fiscal year 2013 of 0.33%. Even by IMF 'rosy' standards this is way off the mark, as other (EU Commission and Cypriot own) forecasts envisioned GDP contracting between 0.5% and 1.3% in 2013.
2. IMF forecast is based on pre-bailout assumptions with the banking sector returns to the economy being at the levels consistent with full functioning of the Cypriot financial services sector.
3. Even outside the above points, IMF forecast through 2017 saw Government debt/GDP ratio in Cyprus rising to 106.11%, prior to the current 'deal' on foot of forecast GDP growth of 2.87% per annum on average between 2013 and 2017.

Now, with the deal:

1. Shrinkage of the financial services sector will be immediate and deep;
2. Deficit financing of any capital investment by the Cypriot Government will cease;
3. New debt is going to be loaded onto the country;
4. Reduced savings and exits by larger depositors will mean reduced revenues for the economy, etc

Much of this was outlined in my previous post on debt sustainability in Cyprus (http://trueeconomics.blogspot.ie/2013/03/2432013-are-cypriot-debt-dynamics-worse.html)

Now, let's do simple exercise. Add EUR10bn to Cypriot debt pile and get scenario of Cyprus (post-crisis with no growth effects).

Then, adjust GDP growth from 2013 through 2017 to yield average rate of economic growth of -0.18% annually (note, this is much more benign than Greek forecasts for the first 5 years of the crisis which are equal to -2.94% annually on average). This yields scenario of Cyprus (post-crisis with growth effects).

The above two scenarios are compared in the chart below against Greek forecasts by the IMF and the pre-'bailout' forecast by the IMF for Cyprus:

This is what the EU leadership is currently celebrating - a wholesale, outright bankrupting of the entire country. Well done, lads!

24/3/2013: Few Cypriot Myths & Few Billions in Losses

Ever wondered why would the IMF (and reportedly the EU Commission) reject the proposed (Plan B) Cypriot Government raid on state pensions funds? Oh... ok... IMF review from November 2011:

Naughty, naughty little Cyprus...

And the very same IMF note also sheds some light on those 'oligarchs' deposits that are so vast, the entire EU is apparently chocking on chicken breasts at Herman von Frompuy's dinners:

"First, non-resident deposits (NRD) in Cypriot banks (excluding deposits raised  abroad by foreign affiliates) are €23 billion (125 percent of GDP), most of which are  short-term at low interest rates [note: ECB official data does not exclude foreign affiliates deposits, which are normally out of touch in levy imposition. Also note: much of bulls**t about Russian oligarchs deposits was about high interest rates allegedly collected by them on Cyprus deposits. Guess that wasn't really the case as chart below confirms: deposit rates decline sharply by nationality grouping for both corporates and individuals... so who was exactly earning 'high returns' on Cypriot deposits? oh, well... Cypriots...].

"These could prove unstable in the event of  further confidence shocks. [In other words, Cyprus requires very stringent capital controls if it is to avoid instantaneous bankruptcy even with ELA continuing]

"This risk is partly mitigated by the 70 percent liquid asset requirement against the €12 billion in NRD in foreign currency), and the 20 percent requirement for the €11 billion in euro-denominated NRD). [Wow, so apparently 'oligarchs' deposits carry massive safety cushions, whilst 'ordinary' depositors are not...]

"Second, €17 billion in deposits collected in the Greek branches of the three largest Cypriot-owned banks could be subject to outflows in response to difficult conditions in Greece. Outflows in the first half of 2011 were close to €3 billion (nearly 15 percent of the total), although a portion of these returned to the Cypriot parents as NRD. [Now, there was more of Greek money than 'oligarchs'?]

Now, couple more revealing charts:

Clearly, structuring PSI the EU authorities & IMF knew the above factoid, right? Just as they knew the following (which clearly highlights the fact that any substantial hit on Cypriot banks would have immediately spelled insolvency of the entire economy):

24/3/2013: Are Cypriot Debt Dynamics Worse than Greek?

A nice chart via Pictet (link) on the size of the banking sector in Cyprus and its dynamics since 2006:

Now, do notice, reducing the above to 300-330% of GDP as required by the Troika in Plan A (and so far not disputed by the Cypriot Government) will imply lowering liabilities by EUR66.6 billion. Overall, banking margins in Cyprus are running at around 1.2% net of funding costs, we can roughly raise that to double to include wages and other costs spillovers, which implies that EUR66.6bn deleveraging of liabilities should take out of the Cypriot GDP somewhere around EUR1.5bn annually or 9% of GDP. Auxilliary services, e.g. legal, accounting and associated expatriate community benefits that arise in relation to international banking services being offered from Cyprus will also have to be scaled back. Assuming that these account for 50% of the margin returns to the economy, overall hit on Cypriot economy from deleveraging can be closer to EUR2.2bn annually or 12.7% of GDP.

Now, consider the loans package of EUR10 billion that Cyprus is set to receive if it manages to close the EUR5.8 billion gap. Absent banking sector deleveraging, this will push Cypriot Government debt/GDP ratio to over 140% of GDP. However, with reduction in GDP, the debt/GDP ratio (assuming to avoid timing considerations assumptions a one-off hit to GDP) will rise to 161%.

Now, recall that IMF and Troika 'sustainability' bound for debt/GDP ratio used to be 120%. We are now clearly beyond that absolutely abstract number even without the banking sector deleveraging. And let's take the path of debt/GDP ratio forecast by the IMF which would have seen - absent the 'rescue' package - debt/GDP ratio in Cyprus rising 106.1% of GDP by 2017. With the 'rescue' package and banking sector deleveraging, this can now be expected to rise to 174% of GDP in 2017 against Greek debt of 153% of GDP.

In short, the EU 'rescue' is going to simply wipe Cyprus off the map in economic terms. All debt 'sustainability' consideration are now out of the window.

Here's the chart:

Of course, the above analysis is crude as it ignores:

1. Potential positive effects of replacement activity and the fabled 'gas revenues' etc - which presumably were already reflected in GDP growth figures in the IMF forecasts
2. Potential negative effects of tourism, real estate sales and other services declines due to the reduced activity in the banking sector, which can raise the above adverse impact of the banking sector deleveraging to 15% of GDP. Corporation tax increases can yield further losses.
3. Timing issues for the deleveraging which is not expected to happen overnight.

Nonetheless, all in, there have to be some severe doubts as to viability of the Cypriot debt path under the Troika Plan A, let alone under the Cypriot Plan B.

22/3/2013: Cypriot Plan B - any better than Plan A?

So the reports are that Cyprus has a Plan B. And the outlines of the Plan - filtering through yesterday - are quite delusional.

The Plan consists of 3 main bits:

1. Split Laiki bank (see below) into a good and a bad bank. The 'bad' bank will take on deposits of over 100K and deposits under 100K (guaranteed by the State) will be shifted into 'good' bank. Other banks will be recapitalised but there are no specific as to how, when or to what levels of capital. This stage of the Plan aims to reduce the recapitalisation costs by about €2.3bn. The problems with this stage are massive, however. First: smaller depositors are more likely to run on the bank as they are less likely to have termed deposits and as their withdrawals (even under capital controls to be imposed - see below) will be less restricted than for larger depositors. In other words, the Plan B is likely to reduce stability of deposits and funding in the resulting 'good' bank. Second: while Cypriot banking system losses are currently crystallised, reducing uncertainty for any recapitalization, there is no guarantee that depositors flight will not undermine their balance sheets beyond capital injections repair. Thirdly: the new 'good' bank will have a balance sheet (again, see table below) saddled with massive exposure to ELA & ECB funding at ca 40% of the total liabilities. If associated assets move along with larger depositors, it is likely that ECB funding ratio to Assets is going to be close to 50%. How on earth can this be called a 'good' bank beats me.

2. Step two in the delirious process of Plan B repairs of the Cypriot banking system will be the creation of a sovereign wealth fund backed by state, church, central bank and pension funds 'assets'. Even 'future gas revenues' are thrown into the pot. Put simply, the fund will be a direct raid on state pension funds, state properties and enterprises and gold reserves. It will also contain a direct link to the collective psychosis induced by the crisis - the pipe dream of Cypriot 'Saudi Arabia of the Mediterranean' Republic. Honestly, folks, this crisis has taught us one thing: the quantity of hope-for oil & gas reserves in the country is directly proportional to the degree of economic / financial / fiscal insolvency of the nation. So, having set up a bogus and bizarre fund (with hodgepodge of assets and a rich dose of 'dreamin in the night' claims to assets) the state will issue 6-year bonds against these 'assets' to raise some €2.5bn. Now, what idiot is going to voluntarily buy into this fund is quite unclear at this stage, but presumably, with bond yields set at crippling levels, the fund will find some ready buyers.

3. Step 3: the remaining shortfall of €1bn is to be covered through a small deposit levy on deposits above 100K.


Laiki bank latest balance sheet summary is provided (via Global Macro Monitor) here:

It is a whooper… with Assets at EUR30.375bn the bank is over 178% of Cypriot GDP. Deposits are at 105% of GDP.

The question is whether this plan, even if acceptable to the EU and ECB, will prevent or even restrict the deposits flight once the Cypriot banking system opens up. The EU Commission is working with Cypriot Government on developing capital controls to stem outflow of funds. But there are serious questions as to whether such capital controls can be imposed in the country that is part of the common market.

Another pesky problem is whether the bonds issued by the fund in Step 2 above will count toward Government debt. Presumably, EU can allow any sort of fudge to be created (e.g. Nama SPV in Ireland) to avoid such recognition. If not, then whole Plan B is a random flop of a dead whale beached on Cypriot shores…

Third pesky issue is what happens if the Fund goes bust. With pension funds committed to it, will the Cypriot state simply default on all of its pensions obligations? deport its pensioners to Northern Cyprus? whack the remaining (I doubt there will be any) Russian 'oligarchs' once again? or invade Switzerland? The Cypriot Government attempted to dress up the Plan B as the means to avoiding hitting small savers and ordinary people with the bank levy. It so far seems like risky leveraging of ordinary retirees and future retirees to plug the very same hole that would have been created in their budgets by the deposits levy.


Meanwhile, here's the question for those reading this blog in Ireland: According to the ESCB Statures Article 14.3, the Governing Council of ECB can make a determination to shut off liquidity assistance to the national banking system only on foot of a 2/3rd majority vote. The ECB Council did announce such a move for Cyprus comes Monday. This implies that at least one peripheral state National Central Bank governor casted the vote against Cyprus. Would that have been our Patrick Honohan, one wonders, given the frequent propensity of Irish officials to kick other peripheral states in order to gain small favours from the EU/ECB?

15/3/2013: IMF Assessment of the Euro Area Banking Sector Risks - part 4

This is the fourth post on today's release by the IMF of the 2013 Financial System Stability Assessment Report for European Union report, and probably last.

The first post - summarising top-line conclusion from the Technical Note on Progress with Bank Restructuring and Resolution in Europe is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area.html

The second post dealt with the Technical Note coverage of the Non-Performing Loans issues: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area_15.html

The third part focused on the real economy side of the banking sector risks within the euro area: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area_5878.html

And related Country Risk Survey study for Q1 2013 covering euro area banking sector risks is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-irish-banks-still-second.html .


This note is focusing on the actual report itself: European Union: Financial Sector Stability Assessment.


Top-level assessment:

Per IMF: "Much has been achieved to address the recent financial crisis in Europe, but vulnerabilities remain and intensified efforts are needed across a wide front:

• "Bank balance sheet repair. Progress toward strong capital buffers needs to be secured and disclosures enhanced. To reinforce the process, selective asset quality reviews should be conducted by national authorities, coordinated at the EU level." [In Irish context, the real review should be carried out, imo, across the quality of capital claimed to be present on banks balance sheets. Rating agencies have highlighted the Ponzi-like risk scheme whereby contingent capital measures are provided by the Sovereign supports whereby neither the Sovereign, nor the banking system can actually sustain a call on capital of any appreciable volume. Asset quality reviews are also needed, as Irish banks are carrying large exposures to unsustainable and already defaulting mortgages.]
• "Fast and sustained progress toward an effective Single Supervisory Mechanism (SSM) and the banking union (BU). This is needed to anchor financial stability in the euro area (EA) and for ongoing crisis management. The European Stability Mechanism (ESM) is to take up its role to directly recapitalize banks as soon as the SSM becomes effective." [It is pretty much clear now that ESM is not going to be deployed unless significant pressure rises on Italy and/or Spain. In this context, calling for 'effective' ESM is like calling for a 'real' Santa Claus. Meanwhile, neither the SSM nor BU can be expected to become functional any time soon. The institutions behind both are yet to be defined, let alone fully legislated. And from legislation line, it's a long distance still to functionality.]

"Restoring financial stability in the EU has been a major challenge. The initial policy response to the crisis was handicapped by the absence of robust national, EU-wide and EA-wide crisis management frameworks. In a low-growth environment,
several EU countries are still struggling to regain competitiveness, fiscal sustainability, and sound private sector balance sheets. Their financial systems are facing funding pressures as a result of excessive leverage, risky business models, and an adverse feedback loop with sovereigns and the real economy."
[This is significant across a number of points. Firstly, in contrast to the European leadership claimed wisdom, the IMF clearly links banking crisis not just to sovereign crisis, but to the real economy, and these links follow not just balance sheet line, but the line of private sector debts. Secondly, the IMF clearly believes that private sector debt overhang is a core structural problem and has contagion implications across the entire system. EU leaders, even in countries heavily impacted by debt overhang, like Ireland, are solely obsessed with banks balance sheets (less) and sovereign finances (more).]

"Much has been done to address these challenges… Nevertheless, financial stability has not been assured. Recent Financial Sector Assessment Program (FSAP) assessments of individual EU member states have noted remaining vulnerabilities to:

• stresses and dislocations in wholesale funding markets; 
• a loss of market confidence in sovereign debt; 
• further downward movements in asset prices; and 
• downward shocks to growth." 

"These vulnerabilities are exacerbated by

• the high degree of concentration in the banking sector; 
• regulatory and policy uncertainty; and 
• the major gaps in the policy framework that still need to be filled."

"The SSM—while critically important––represents only one of a number of crucial steps that need to be taken to fill key gaps in the EU’s financial oversight framework.

• "As crisis tensions abate, it is important that the implicit unlimited sovereign guarantees in place for the last several years be effectively removed through affirmation and implementation of the principle that institutions with solvency problems must be resolved." [Note: in Ireland's case once again there is a departure from this principle - we are, simply put, not resolving insolvent institutions presence in the market. Instead, we are continuing to deleverage and consolidate the insolvent banking sector at the expense of its future viability and current borrowers and non-financial companies requiring credit. Resolving insolvency - especially after 4.5 years of supports - requires shutting down insolvent banks. That would de facto mean survival of the Bank of Ireland and significantly slimmed down AIB. And that's all. None else. We are far, far away from the Government even considering such an action, which means that the zombified banking sector will continue extract excessive rents out of stressed borrowers and businesses in this country for years to come all to dress up the banking sector 'stabilisation' whilst achieving no structural resolution of the crisis.]
• "The Single Resolution Mechanism (SRM) should become operational at around the same time as the SSM becomes effective. Resolution should aim to minimize costs to taxpayers, as well as to deposit insurance and resolution funds, without disrupting financial stability." [The sheer nonsense of this statement is exposed by the core EU authorities insistence that ESM will not apply retrospectively. In other words, the ESM will be a promise of a miracle cure to the dying patient contingent of the patient surviving for a number of years required to devise the cure. And the same applies to the last two points below.]
• "This should be accompanied by agreement on a time-bound roadmap to set up a single resolution authority, and common deposit guarantee scheme (DGS), with common backstops." 
• "Guidelines for the ESM to directly recapitalize banks need to be clarified as soon as possible, so that it becomes operational as soon as the SSM is effective."

So here you go, folks, per IMF, there's an ambulance to help the injured, but currently it exists only on the paper and even as such it is still pretty much unworkable. Good luck with setting up that triage, mates.

15/3/2013: IMF Assessment of the Euro Area Banking Sector Risks - part 3

This is the third post on today's release by the IMF of the 2013 Financial System Stability Assessment Report for European Union report.


The first post - summarising top-line conclusion from the Technical Note on Progress with Bank Restructuring and Resolution in Europe is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area.html

The second post dealt with the Technical Note coverage of the Non-Performing Loans issues: http://trueeconomics.blogspot.ie/2013/03/1532013-imf-assessment-of-euro-area_15.html

And related Euromoney Country Risk Survey study for Q1 2013 covering euro area banking sector risks is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-irish-banks-still-second.html .

This note is focusing on the Technical Note on Financial Integration and Fragmentation in the European Union.


Let's start with a fascinating chart showing the sources of financing for the real economy in the EU compared to the US:

The scary bit here is the overall significant imbalances built in the system of financing in the EA17, compared to Denmark, and to the US:

• Thin bond markets across ALL euro area states
• Inexistent private credit markets
• Imbalanced over-reliance on bank credit
• In the case of Ireland, Netherlands, Spain, Cyprus, Portugal, Austria, Italy, Germany, Malta, Finland and Greece - mature markets were characterised with exceptionally thin or thin equity markets

And as chart below shows, euro area is also suffering from extreme over-concentration of the banking credit markets in the hands of the 'globally systemically important banks' (G-SIBs):

Per IMF: "The main EU banking systems are dominated by a set of globally systemically important banks (G-SIBs). These European G-SIBs have grown in size and importance and are highly interconnected with the rest of the global financial system (see Annex 1). Their assets more than tripled since 2000, amounting to US $27 trillion in 2010. As key players in global derivatives and cross-border interbank markets, they are also among the most interconnected GSIBs. European G-SIBs tend to be larger and more leveraged than their peers. In particular, they are very large relative to home country GDP, and in many EU countries, their size may dwarf the capacity of the home government to raise revenues."

Per footnote, this over-concentration is driven by the legacy models of banking in the euro area: "In part this is because European banks tend to follow the universal banking model, which combines a range of retail, corporate, and investment banking activities under one roof. There are some accounting differences that would make the balance sheets of the IFRS-reporting banks appear more “inflated” than the balance sheets of banks reporting under the U.S. GAAP (e.g., netting of derivative and other trading items is only rarely possible under IFRS, but netting is applied whenever counterparty netting agreements are in place under U.S. GAAP)."

Not surprisingly, banking sector stress directly links to the real economy and even more so to the sovereign positions:

And, within the real economy, the crisis is hitting the hardest the SMEs: "The deleveraging process raises concerns about a credit crunch that would particularly affect SMEs. SMEs in peripheral Europe are particularly hard hit by the deleveraging process, as deposit outflows and capital shortages at banks limit the availability and raise the cost of bank loans. Data from the European Commission and European Central Bank Survey on the Access to Finance of SMEs show that the availability of external finance from banks has decreased since 2009 while the demand for external finance has increased.

"However, there is much cross-country variation, with the availability of external finance having deteriorated markedly since 2009 in Greece and Ireland and having remained fairly stable in countries like Finland and Germany. Regression analysis suggests that the deterioration in the supply of credit to SMEs is partly driven by the financial dis-integration process, as measured by the decline in cross-border BIS claims."

Which, of course, is not surprising - Big Banks Dominance = Closer Links to the Governments and Big Business via the Social Partnership / Corporatist models for governance.

So, great stuff, Messr Kenny & Noonan - Irish banks (duopoly-modeled super-concentration with above average links to sovereigns and some of the most aggressive delveraging plans on the books within the EA17) offer as much hope of restarting lending to SMEs as that of sustaining viable rice growing industry in Sahara.


The next post will continue with my analysis of the IMF report and technical notes. Stay tuned for more later tonight.

15/3/2013: IMF Assessment of the Euro Area Banking Sector Risks - part 2

This is the second post on today's release by the IMF of the 2013 Financial System Stability Assessment Report for European Union report.

The first post - summarising top-line conclusion from the Technical Note on Progress with Bank Restructuring and Resolution in Europe is available here:


And related Euromoney Country Risk Survey study for Q1 2013 covering euro area banking sector risks is available here: http://trueeconomics.blogspot.ie/2013/03/1532013-irish-banks-still-second.html .

Some beef on the Non-Performing Loans (NPLs):

"NPLs in EU banks continue to rise, outpacing loan growth (Figure 4). Since 2007, loans to the economy have decreased by 3 percent while NPLs increased by almost 150 percent, i.e., €308 billion in absolute terms. And, this trend shows no sign of reversal, reflecting the continued macro deterioration in parts of the EU and the absence of restructuring."

"When NPLs remain on balance sheets, they absorb management capacity, and continued losses can weaken banks’ profitability. They can also foster forbearance, thereby deterring new investors by impairing transparency. In several countries, independent asset quality reviews and stress tests have facilitated a diagnosis of the quality of banks’ assets, supporting prospects for private recapitalization."

Per IMF note: NPLs have jumped from 2.6 percent in December 2007 to 8.4 percent of total loans in June 2012

Euro area periphery is worst-hit, for obvious reasons: "NPLs across EU banks differ largely, with those in the “peripheral” countries (Greece, Ireland, Italy, Portugal and Spain) witnessing the largest increases. For instance, from December 2007 to June 2012, the NPL ratio for Italy increased by 2.5 times, while in Spain, the increase was seven times (Figure 5). Ireland stands out with average NPLs of around 30 percent, followed by Hungary and Greece. However, definitions in this area remain non-harmonized and impair comparability across the EU".

Now, note that 'turned-the-corner' Ireland is in the league of its own when it comes to NPLs ratio to total loans. Taken to the average ratio of total loans to GDP, Irish NPLs must be absolutely stratospheric.


And now, onto IMF view of the NPL resolution processes in the euro area (again, italics are mine and all quotes are directly from the IMF note):

"Borrower restructuring needs to be facilitated, with legal hurdles lifted. The legal framework should facilitate the restructuring of NPLs and maximize asset recovery. In several EU countries, including Italy, Greece and Portugal, the IMF is involved in bankruptcy/insolvency law reform, including by introducing fast track restructuring tools and out-of-court restructuring process. For instance, repossession of the collateral backing a retail mortgage may take several years in Italy versus few months in Scandinavia and United Kingdom. The asset recovery process is also very prolonged in many EEE countries."

[Do note absence of IMF input in the case of Ireland and that is a general gist of the Note - it simply passes no assessment of the Irish personal insolvency regime 'reforms', which is strange given the prominence of these reforms and the fact that these are the first comprehensive reforms in the euro area periphery. Personally, I read this lack of analysis as the IMF reluctance to endorse the Irish Government approach to the NPLs resolution when it relates to mortgages.]

"An efficient framework for handling NPLs is key to rehabilitate viable borrowers and provide the exit of non-viable borrowers."

[Note the IMF emphasis on rehabilitating viable borrowers AND providing the exit for non-viable borrowers. These twin objectives strike contrast with the Irish Government approach to resolving the personal insolvencies and mortgages crises. Instead of rehabilitating viable borrowers, the Irish Government is pursuing an approach of giving the banks full power to avoid any writedowns of the loans, even when such writedowns can define the difference between rehabilitation and insolvency. When it comes to providing exit for non-viable borrowers, the Irish Government has adopted the approach of reforming the personal insolvency regime from 12 years bankruptcy duration to 3 years, but then extended the process of availing of the bankruptcy from few months to up to 3 years. The pre-bankruptcy period of up to 3 years under the new regime is a period during which the banks have full power to extract all resources out of the households with little protection for the household, in contrast with the previous bankruptcy regime. Thus, in terms of life-cycle financial health, Irish households going through the new reformed personal insolvency process are unlikely to gain any meaningful relief compared to the previous regime.]

"Active management of NPLs is needed. In principle, NPLs can either be:

1. retained and managed by banks themselves at appropriately written-down values, while the banks receive financial assistance from the government for recapitalization; or
2. relocated or sold to one or more decentralized “bad banks,” loan recovery companies, or Asset Management Companies (AMCs) that specialize in the management of impaired assets; 
3. sold to a centralized AMC set up for public policy purposes (possibly when the size of NPLs reaches systemic proportions)."

IMF also notes that: "The European Banking Coordination “Vienna” Initiative (2012) in a working group focused on NPL issues in Central, Eastern and Southeastern Europe. Recommendations, among others, focused on establishing a conducive legal framework for NPL resolution, removing tax impediments and regulatory obstacles, as well as enabling out-of-court settlements."


Stay tuned for the third and subsequent posts covering other technical notes released by the IMF.

15/3/2013: IMF Assessment of the Euro Area Banking Sector Risks - part 1

Today's releases of the horror flicks starring Irish financial sector are up and running, folks.

As noted in the previous note - premiering Q1 2013 article on euro area banking sector analysis from Euromoney Country Risk surveys (link: http://trueeconomics.blogspot.ie/2013/03/1532013-irish-banks-still-second.html) - the IMF has released today 2013 Financial System Stability Assessment Report for European Union report.


This is the first blog post on the report and associated technical papers, and it covers the Technical Note on Progress with Bank Restructuring and Resolution in Europe.


From the top-line conclusions by the IMF (all quotes marked, italics within quotes are mine):

1. "The European Union (EU) banking system restructuring is under way, but is far from complete. Some bank restructuring has started, and the level Tier 1 capital ratios of EU banks have been substantially increased."
2. "But system-wide, capital ratios have been met partly by deleveraging or recalibrations of the risk weights on activities."
3. "Consolidation in the banking sector has been slow, with banks rarely closed."
4. "Nonperforming loans are building up in banks’ balance sheets, and addiction to central bank liquidity remains high especially for banks in peripheral countries."
5. "Despite the EBA recapitalization exercise having led to €200 billion of new capital or reduction of capital needs by European banks, fresh capital is difficult to attract in an environment where prospects for profitability are uncertain."
6. "Several hurdles impair restructuring and resolution in Europe, and urgent progress needs to be made:

• "First, EU bank resolution tools need to be strengthened, aligning them with the Financial Stability Board Key Attributes for Effective Resolution. Fast adoption of the EU resolution directive is welcome, but enhancements are warranted. Swift transposition should follow." [We are still ages away from having any effective resolution tools and any sort of functional regulatory consolidation, let alone functional and effective supervisory consolidation.]
• "Second, restructuring of nonperforming loans (NPLs) should be facilitated [more on this below]. The legal framework should not slow down restructuring and maximize asset recovery. In several EU countries, such as Italy, Greece and in Eastern Europe, bankruptcy reforms lag behind in that, for instance, current practice does not allow the seizure of collateral in a reasonable timeframe. Banks should also manage more actively their NPLs, possibly allowing a market for distress assets to emerge in Europe." [Note the absence of Ireland in the list of laggards above. It is generally strange that the IMF is avoiding passing any judgement on the only case of actual reforms that has impacted only one of the peripheral countries.] 
• "Third, further evolution of the General Directorate for Competition’s (DG COMP) practices will be needed in systemic cases to ensure consistency with a country’s macro-financial framework and support viability of weak banks, recovery of market access, and credit provision. Increased transparency would give added credibility and accountability." [Again, we are ages away from delivering on these.]
• "Fourth, disclosure should be significantly enhanced and harmonized by the EBA, to restore market confidence. In particular, interpretable metrics regarding the quality of banks’ assets, in terms of NPLs, collateral, probability of defaults (PD) and loan recovery rates (LGD) are key for assessing the strength of banks and restoring confidence in the banking system." [see comment above]

Summary: what needs to be done is, largely, nowhere to be seen, yet...

Update:


And when it comes to much of hope of the forthcoming regulatory changes altering the status quo of the dysfunctional regulatory system, don't hold your breath, folks.

The Big Hope is on the forthcoming EU resolution directive aiming to create coordinated system of responses to any future structural financial crises. Here's IMF view on that one:

• First, polite stuff: "A critical new EU resolution directive is in preparation. As a national approach to resolution may well not be appropriate in the EU given the importance of cross-border banking, and the failure of existing cross-country coordination mechanisms, the European Commission (EC) has taken steps to harmonize and strengthen domestic resolution regimes. This should help avoid regulatory arbitrage and make orderly resolution effective and efficient for cross-border banks. In June 2012, the Commission issued a draft directive for harmonized crisis management and resolution framework in all EU countries. The Irish Presidency will make the adoption of the resolution framework a top priority and plans to adopt it during the first part of 2013. The new national resolution regimes endow EU countries with strong early intervention powers and resolution tools. The transposition of the directive into national laws should be accelerated relative to the current deadlines (01/2015, and 01/2018 for bail-ins)."

I wrote about this Directive recently (http://trueeconomics.blogspot.ie/2013/02/2422013-eus-banking-union-plan-can.html) and was not too enthusiastic. Alas, here's IMF's less pleasing assessment, although dressed up in polite language of 'suggestions':

• "Box 1. Proposed Resolution Directive––Risks and Areas for Enhancements

1. Resolution of banks is undermined by the absence of a more effective EU-wide framework to fund resolution. Binding mediation powers for the EBA and mutual borrowing arrangements between national funds face inherent constraints (in particular, the EBA cannot impinge on the fiscal responsibilities of EU member states).
2. Passage of the directive will substantially enhance the range of tools available to resolution agencies in the EU. But the scope of the directive should be widened to include systemic insurance companies and financial market infrastructures. The European Commission launched a consultation at the end of 2012 on this issue. All banks should be subject to the regime, without the possibility of ordinary corporate insolvency proceedings.
3. The breadth and timing of the triggers for resolution should be enhanced by providing the authority with sufficient flexibility to determine the non-viability of the financial institution (including breaches of liquidity requirements and other serious regulatory failings, not just capital/asset shortfalls). There should be provision for mandatory intervention in the event a specified solvency trigger is crossed.
4. The directive affords less flexibility for using certain resolution powers than the key attributes. For instance, it does not permit exercising the mandatory recapitalization power and the asset separation tool on a standalone basis. Also, bail-in safeguards should not prevent departure from pari passu treatment where necessary on grounds of financial stability or to maximize value for creditors as a whole.
5. Depositor preference should be established for insured depositors2, with the right of subrogation for the DGS."

Thus, to sum up the best-hope response of the EU - it is useless, largely toothless and predominantly weak. And to add to this - it will only be fully functions in 2018! You might as well think we live in a Natural History museum, where urgency of response is differentiated by months, rather than minutes.




Next post will cover the issue of Non-Performing Loans.

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.

15/2/2013: Euro Area Banks: Staff & Admin Costs 2008-2011

Brilliant data set on Staff and Admin costs in domestic banking sectors across the Euro Area (H/T to Lorcan Roche Kelly aka @LorcanRK via twitter), via ECB (link) :

So run through these. Over 2008-2001, Admin & Staff costs in banks:

• Declined by 7.84% across the entire Euro Area;
• Went up in Cyprus by a massive 21.9% (banks are now bust), in Spain by 12.16% (banks are largely bust), in Portugal by +4.26% (many banks are zombified)
• Fell marginally by  -0.05% in Italy (some larger banks in pretty dire shape), -3.2% in Greece (banks are bust).
• Fell significantly in Ireland by -26.4% (banks are bust), Luxembourg by 36.5% (brassplates operations), and by 31.3% in shaken Estonia (banks are operating in high risk, low growth environment). Fell consistently in line with overall state of the crisis across the banks-related sectors of the economy in the Netherlands (-10.81%) and overshooting economy's woes in Belgium (-23.2%).
• Fell massively in Germany, where overall banking sector was not as badly mangled (-59.6%).

Go figure...

19/1/2013: Euro area banks need EUR400bn in capital: OECD

An interesting article via Euromoney (January 14, 2013) on European banks facing EUR400bn in capital shortfall estimated by the OECD.

A quote:

"A chief gripe is the extent to which European banks have refused to acknowledge their losses and write down bad loans, echoing the comedy of errors that has blighted Japan in recent decades.

... the European Banking Authority’s (EBA) financial stress test in June 2011 – which determined the capital-raising target for the regional banking system for 2012 – was based on an excessively benign treatment of the coverage ratio.

The median coverage ratio of the 90 European banks examined in the test was just 38% to meet the 9% core tier 1 capital ratio target. By contrast, the coverage ratio -  which indicates the amount of reserves banks have set aside relative to a pool of non-performing loans - for US banks equated to 67% in the first quarter of 2011, according to the Federal Deposit Insurance Corporation. ...

In a November report, before the Draghi ‘put’, Deluard noted: “In its mild form, European banks’ refusal to recognize losses could lead to a Japanese ‘lost decade’: banks evergreen their loans [ie, rolling over loans to borrowers who are unable to pay], regulators agree to play the ‘extend and pretend’ game, and the credit creation mechanism is permanently clogged."

And this week "the OECD, headed by Angel Gurria, added to the chorus of criticism – in contrast to the EBA’s upbeat assessments – by stating that the ratio of core tier 1 capital to unweighted assets of eurozone banks falls well short of 5% “in many cases”. On this benchmark, European banks face a €400 billion capital shortfall, or 4.5% of the eurozone’s GDP."

The OECD’s concern echoes that of the IMF, the Bank of England and the Basel Committee: "banks have inflated their asset values, despite the EBA’s self-congratulatory claim in July 2012 that banks in the region had reached a minimum 9% of the best quality core tier 1 capital to risk-weighted assets, in excess of the current international requirements."

And as OECD points out, the problem is much more than just 'peripheral' banks - the problem is Germany and France.

Here are two slides from my recent presentation on banking sector (I was planning to present more on this at the Irish Economy conference on February 1, but the session on banking got canceled, so will be posting the full slide deck here in few days time - stay tuned).

23/12/2012: Not another cent?.. Irish banks state aid 2011

In the previous post, amidst the excitement of the aggregate figures reporting, I forgot one small, but revealing chart.

Now, recall the FG/LP election campaign promise of 'not another cent' for the banks?..

23/12/2012: State Aid in EU27 & Ireland

Yesterday, the EU Commission released updated analysis of state aid expenditures, covering 2012 data. The document, titled "State aid Scoreboard 2012 Update Report on State aid granted by the EU Member States - 2012 Update" is available here.

Here are some interesting bits:


"Between 1 October 2008 and 1 October 2012, the Commission approved aid to the financial sector totalling €5,058.9 billion (40.3% of EU GDP). The bulk of the aid was authorised in 2008 when €3,394 billion (27.7% of EU GDP) was approved, mainly comprising guarantees on banks’ bonds and deposits. After 2008, the aid approved focused more on recapitalisation of banks and impaired asset relief rather than on guarantees, while more recently a new wave of guarantee measures was approved mainly by those countries experiencing an increase in their sovereign spreads, such as Spain and Italy.

Between 2008 and 2011,  the overall amount of aid used  amounted to  €1,615.9 billion (12.8% of EU GDP).  Guarantees accounted for the largest part amounting to roughly €1,084.8 billion (8.6% of EU GDP), followed by recapitalisation €322.1 billion (2.5% of EU GDP), impaired assets €119.9 (0.9% of EU GDP) and liquidity measures €89 billion (0.7% of EU GDP)."


In other words, keeping up the pretense of solvency in the legacy banking system of the EU (primarily that of the EA17) has created a cumulated risk exposure of €5.06 trillion (over 40% of the entire EU27 GDP). With such level of supports, is it any wonder there basically no new competition emerging in the sector in Europe.


"In 2011, the Commission  approved aid to the financial sector  amounting to  €274.4 billion (2% of EU GDP). The new aid approved was concentrated in a few countries and involved guarantees for €179.7 billion, liquidity measures for € 50.2 billion, recapitalisations for €38.1 billion and impaired asset relief for € 6.4 billion.

The overall volume of aid used in 2011 amounted to € 714.7 billion, or 5.7% of EU GDP. Outstanding guarantees stood at € 521.8 billion and new guarantees issues amounted to €110.9 billion. Liquidity interventions amounted to € 43.7 billion and new liquidity provided in 2011 stood at €6.5 billion. Recapitalisation amounted to € 31.7 billion. No aid was granted through the authorised impaired assets measures."

Some illustrations of historical trends.

First non-crisis aid:

Amongst the euro area 12 states, Ireland has the fourth highest level of state aid over the period 1992-2011 and this is broken into 5th highest in the period of convergence with the EA12 (1992-1999), 5th highest for the period of the monetary bubble formation (2000-2007) and the second highest for the period of the crisis (2008-2011).

Relative to EU27, Irish state aid was above EU27 average in 1992-1994, 1998-2002, 2007-2011. In other words, Ireland's state aid was in excess of EU27 for 13 out of 20 years. And that despite the fact that our income convergence to the EU standards was completed somewhere around 1998-1999.

In terms of financial sector supports during the crisis, we are in a unique position:

The overall level of supports for financial sector in Ireland is so out of line with reality that our state aid to insolvent financial institutions stood at 365% of our GDP in 2011 or roughly 460% of our GNP. In other words, relative to the size of our economy, the moral hazard created by the Government (and Central Bank / FR) handling of the financial crisis in Ireland is now in excess of measures deployed by the second and third worst-off countries in EU27 (Denmark and Belgium) combined.

The chart above shows that Guarantees amounted to 246.7% of GDP in Ireland, almost identical to 245.7% of GDP in Denmark. Which means that our Guarantees were basically equivalent to those of seven worst-off Euro area countries combined.

However, stripping out the Guarantees, the picture becomes even less palatable for Ireland:

Ex-Guarantees, Irish State supports for the financial sector were more than 10 times the scale of EU27 supports and at 118.4% of GDP amounted to almost the combined supports extended by all EA12 states (123.2% of GDP).

1/12/2012: Irish banking Reforms: are things getting better?

In the previous post, I discussed changes in irish banking system systemic stability in 2012 (January-November). But here's a longer range view - from September 2010 on through November 2012.

Now, keep in mind: since September 2010, Irish banks had

1. Massive recaps (2011-2012)
2. Full reform and deleveraging programmes, approved by the EU and Irish authorities
3. Rounds of increases in charges on customers to beef their own interest margins
4. Vast subsidies from the ECB and CBofI
5. Subsidies from the Government via deposits (see here)
6. According to the Government, BofI (largest bank) has completed its deleveraging programme, while AIB (second largest bank) is ahead of target
7. Massive sales of riskiest assets to Nama that crystalized losses and led to recaps, which are now completed
8. According to the Government have bee operating in more benign environment of property prices stabilization
9. Benefited from a 88% rally in Government bonds which they stuffed onto their balancesheet over 2010-present like there is no tomorrow

and so on. In other words, there are tomes and tomes of Government sponsored propaganda to suggest that things are going honky-dory in the banking sector in Ireland. Here's what Head of the Department of Finance had to say this week about the banking sector 'progress' (emphasis is mine):

"With PCAR capital investments and the Bank of Ireland sale, confidence started to return to the banking sector. [this refers to 2011]"

"In 2012 we have witnessed further tangible signs of stability. …Even though non-performing loans continue to grow; here again there are tentative signs that in the mortgage arrears area the growth in new arrears has been arrested. 

The banks still have a lot of work to do to roll out sustainable mortgage solutions, but this process is underway.

Importantly, confidence is returning to our banking system following its recapitalisation.  Deposits across the Irish system are up 2.5% with stronger growth recorded by AIB, BOI and PTSB (which are up 5.3%).

We are in a situation now where the domestic banking system is getting stronger, albeit from a very weak starting point.

• The large scale balance sheet restructuring has been completed;
• BOI have completed the disposal of non-core portfolios
• AIB have substantially completed their disposals. 
• The funding gap has been significantly reduced and the drawing on Eurosystem funding by our government supported going-concern banks continues to decline, and is now less than €60 billion (excluding IBRC).
• Importantly, as I said earlier deposits are growing and the banks are back in the funding markets."

So, in other words, we should expect Ireland's banking system to have performed well in progressing since 2009-2010 lows?

Here's the chart:

In reality, courtesy of Euromoney surveys, we know that Irish banking system stability has deteriorated, not improved, between September 2010 and November 2012, and this deterioration was the second largest amongst 37 European countries.

1/12/2012: Ireland - still the second worst banking sector in EA

Another Euromoney risk survey on and the results for the banking sector are out:

Ireland's banking sector zombies are ranked as 4th least safe in the entire Europe of 37 countries. Next to Greece (3rd least safe), and Macedonia (1 place ahead of Ireland - 5th least safe). Iceland, having defaulted and demolished its banks, ranks 7th least safe. Note, Ireland remains the second weakest banking sector in the EA17.

Of course, our 'leaders' would say that yes, things are bad, but they are improving... hmm...

Are they? Well, sort of. Ireland's score (higher score, greater systemic stability) have risen in 11 months of 2012, but the rise was far from spectacular. Ireland's improvement in the score is 7th largest in the sample, behind that for Iceland.

Ireland's gap to the peers (Advanced Small Open Economies) in overall score is about 4.4 points. 11 months of heroic Government reforms have yielded a gain of 0.2 points in Irish position, and the deterioration in the overall euro area climate has resulted in a decline in the average ASOE score of 0.07 points. This means the spread improved in favour of Ireland by less than 0.3 points in 11 months - a rate of 'reforms' that can close the current gap, assuming continued deterioration in ASOE average, over  161 months. In other words, unless the 'reforms' in Ireland's banks start bearing fruit much faster than they have done in 11 months of 2012 so far, it will take us 13.4 years to reach ASOE average levels of banking system stability.