28/4/17: Euromoney on Italian Risks

Euromoney article on the continued evolution of the Italian crisis: http://www.euromoney.com/Article/3712913/Country-risk-Italy-is-the-volcano-waiting-to-erupt.html, quoting - amongst others - myself.

19/9/16: FocusEconomics: The Italian Dilemma

Good post from FocusEconomics on the saga of Italian banking crisis: http://www.focus-economics.com/blog/posts/the-italian-dilemma-weak-banks-pose-risk-to-already-faltering-domestic-demand.

And an infographic from the same on the scale of the Italian banking woes:

Click to enlarge

It is worth noting that in the Italian banking case, asset quality crisis (NPLs etc) and compressed bonds returns (yield-related income decline due to ECB QE) are coinciding with elevated macroeconomic risks, as noted by the Tier-3 ranking for Italy in Euromoney Country Risk surveys:

1/7/16: Sunday Night Bailout: Italy

As I have noted on Twitter and in comments to journalists, Brexit has catalysed investors' attention on weaker banking systems. As opposed to the UK banks, that are doing relatively well, given the circumstances, the focal point of the Brexit fallout is now Italian banking system, saddled with excessively high non-performing loans risks and with assets base that is, frankly, toxic, given their exposure to Italian debt and corporates.

Take a look at Kamakura Corporation's data on default probabilities across European financial institutions:

Nine out of twenty five top European financial institutions suffering massive increases in default probabilities over the last 30 days and 90 days are Italian, followed by five Spanish ones. Of five UK institutions on the list, only two are sizeable players worth worrying about.

Not surprisingly, as reported by the WSJ (link here) the EU Commission has approved, quietly and discretely, over Sunday last, use of Italian government guarantees "to provide liquidity support to its banks, ...disclosing the first intervention by a European Union government into its banking system following the U.K. vote to leave the EU." The programme includes EUR150 billion in Government guarantees and is supposed to ease the short term concerns about Italian banks that, based on Italian officials estimates will require some EUR40 billion of new capital.  No one quite has any idea who on earth will be supplying capital to the banks heavily weighted by high NPLs, burdened with massive fallouts in equity valuations and faced with low returns on their 'core' assets (especially Government bonds).

As WSJ notes: "Italian banks have lost more than half of their market capitalization since the beginning of the year, as investors fret about some EUR360 billion in bad loans still logged on their balance sheets. That drop in market value compares to an average decline of less than one third for European lenders. Some Italian banks have seen their shares plummet by some 75% in the first half of the year." Anyone looking into buying into their capital raising plans needs to have their heads examined.

Of course, we know that there is only one ready buyer for the Italian banks 'assets' - the Italian state. Back in April this year, Italy announced the creation of the Atlante fund, designed to "buy shares in Italian lenders in a bid to edge the sector away from a fully-fledged crisis".

As noted in an FT article (link here): "the fund... can also buy non-performing loans." The background to it is that "Italian banks have made €200bn of loans to borrowers now deemed insolvent, of which €85bn has not been written down on their balance sheets. A broader measure of non-performing debt, which includes loans unlikely to be repaid in full, stands at €360bn, according to the Bank of Italy. So is Atlante — with about €5bn of equity — really enough to keep the heavens in place?"

Sh*t no. Not even close to being enough. Which means the State is now fully hooked in banks risks. As the FT article details, the idea is that the Italian Government will buy lower-seniority tranches of securitised trash [sorry: assets] at knock-down prices, leaving senior tranches to private markets. In other words, the Italian Government will spend few billion euros borrowed from the markets to subsidise higher valuations on senior tranches of defaulting loans.

An idea that such schemes are anything other than Italian taxpayers throwing cash at the burning building of the country banking system is naive. Despite all the European assurances that the next bailout will be 'different', it is clear that little has changed in Europe since the days of 2008.

28/2/16: Deutsche Bank post covered in Turkey

Turkish channel Kanal Finans covers my post on Deutsche Bank trials & tribulations: http://kanalfinans.com/one-cikanlar/bir-deutsche-bank-krizi-vardi-ne-oldu-sant-manukyan.

Original post here: http://trueeconomics.blogspot.com/2016/02/12216-deutsche-bank-crystallising.html.

27/7/15: IMF Euro Area Report: The Sick Land of Banking

The IMF today released its Article IV assessment of the Euro area, so as usual, I will be blogging on the issues raised in the latest report throughout the day. The first post looked at debt overhang.


So here, let's take a look at IMF analysis of the Non-Performing Loans on Euro area banks' balance sheets.

A handy chart to start with:

The above gives pretty good comparatives in terms of the NPLs on banks balance sheets across the euro area. Per IMF: "High NPLs are hindering lending and the recovery. By weakening bank profitability and tying up capital, NPLs constrain banks’ ability to lend and limit the effectiveness of monetary policy. In general, countries with high NPLs have shown the weakest recovery in credit."

Which is all known. But what's the solution? Ah, IMF is pretty coy on this: "A more centralized approach would facilitate NPL resolution. The SSM [Single Supervisory Mechanism - or centralised Euro area banking authorities] is now responsible for euro area-wide supervisory policy and could take the lead in a more aggressive, top-down strategy that aims to:

• Accelerate NPL resolution. The SSM should strengthen incentives for write-offs or debt restructuring, and coordinate with NCAs to have banks set realistic provisioning and collateral values. Higher capital surcharges or time limits on long-held NPLs would help expedite disposal. For banks with high SME NPLs, the SSM could adopt a “triage” approach by setting targets for NPL resolution and introducing standardized criteria for identifying nonviable firms for quick liquidation and viable ones for restructuring. Banks would also benefit from enhancing their NPL resolution tools and expertise." So prepare for the national politicians and regulators walking away from any responsibility for the flood of bankruptcies to be unleashed in the poorly performing (high NPL) states, like Cyprus, Greece, Ireland, Italy, Slovenia and Portugal.
• And in order to clear the way for this national responsibility shifting to the anonymous, unaccountable central 'authority' of the SSM, the IMF recommends that EU states "Improve insolvency and foreclosure systems. Costly debt enforcement and foreclosure procedures complicate the disposal of impaired assets. To complement tougher supervision, insolvency reforms at the national level to accelerate court procedures and encourage out-of-court workouts would encourage market-led corporate restructuring."
• There is another way to relieve national politicians from accountability when it comes to dealing with debt: "Jumpstart a market for distressed debt. The lack of a well-functioning market for distressed debt hinders asset disposal. Asset management companies (AMCs) at the national level could support a market for distressed debt by purchasing NPLs and disposing of them quickly. In some cases, a centralized AMC with some public sector involvement may be beneficial to provide economies of scale and facilitate debt restructuring. But such an AMC would need to comply with EU State aid rules (including, importantly, the requirement that AMCs purchase assets at market prices). In situations where markets are limited, a formula-based approach for transfer pricing should be used. European agencies, such as the EIB or EIF, could also provide support through structured finance, securitization, or equity involvement." In basic terms, this says that we should prioritise debt sales to agencies that have weaker regulatory and consumer protection oversight than banks. Good luck getting vultures to perform cuddly nursing of the borrowers into health.

Not surprisingly, given the nasty state of affairs in Irish banks, were NPLs to fall to their historical averages from current levels, there will be huge capital relief to the banking sector in Ireland, as chart below illustrates, albeit in Ireland's case, historical levels must be bettered (-5% on historical average) to deliver such relief:

Per IMF: "NPL disposal can free up large volumes of regulatory capital and generate significant capacity for new lending. For a large sample of euro area banks covering almost 90 percent of all institutions under direct ECB supervision, the amount of aggregate capital that would be released if NPLs were reduced to historical average levels (between three and four percent of gross loan books) is calculated. This amounts to between €13–€42 billion for a haircut range of between zero and 5 percent, and assuming that banks meet a target capital adequacy ratio of 13 percent. This in turn could unlock new lending of between €167–€522 billion (1.8–5.6 percent of sample countries’ GDP), provided there is corresponding demand for new loans. Due to the uneven distribution of capital and NPLs, capital relief varies significantly across euro area countries, with Portugal, Italy, Spain, and Ireland benefiting the most in this stylized example."

A disappointing feature, from Ireland's perspective, of the above figure is that simply driving down NPLs to historical levels will not be enough to deliver on capital relief in excess of the average (as shown by the red dot, as opposed to red line bands). The reason for this is, most likely, down to the quality of capital held and the impact of tax relief deferrals absorbed in line with NPLs (lowering NPLs via all but write downs = foregoing a share of tax relief).

Stay tuned for more analysis of the IMF Euro area report next.

26/6/15: Grexit and European Banks

In the tropical heat of #Grexit, which banks get sweats, which get chills? Two charts via @Schuldensuehner :

and

Note increased (speculative) exposures at Deutsche and Barclays, RBS and Commerzbank... which kinda jars with the conventional wisdom of uniformly reduced exposures. Total end of 2014 exposures were at USD44.5 billion, which is basically marginally down on Q4 2012-Q4 2014 period.

You can see pre-crisis debt flows within the Euro area here: http://trueeconomics.blogspot.ie/2014/12/27122014-geography-of-euro-area-debt.html.

7/5/15: Europe's Non-Performing Loans: Still Rising & Getting More Toxic

In the world of scary stats, there's no place like Europe.

Even the perennial optimists at the IMF - that place where any debt is sustainable as long as there are structural reforms underway - agrees. This is why the IMF published this handy chapter as a part of its Global Financial Stability Report for Q1 2015 (http://www.imf.org/External/Pubs/FT/GFSR/2015/01/pdf/c1.pdf).

In this report it said that [italics are mine]: "Asset quality continued to deteriorate in the euro area as a whole in 2014, although at a slowing pace, with total nonperforming loans now standing at more than €900 billion. Furthermore, the stock of nonperforming loans in the euro area is unevenly distributed, with about two-thirds located in six euro area countries. [The stock of nonperforming loans in Cyprus, Greece, Ireland, Italy, Portugal, and Spain in total amounts to more than €600 billion]. In Cyprus, Greece, Ireland, Italy, Portugal, and Slovenia, a majority, if not all, of the banks involved in the ECB’s Asset Quality Review were found to have nonperforming assets of 10 percent or more of total exposure."

Roll in two super scary charts:

So far so bad… But it gets worse. "These bad assets are large relative to the size of the economy, even net of provisions. Euro area banks have lagged the United States and Japan in the early 2000s in their write-offs of these bad assets, suggesting less active bad debt management and more limited improvement in corporate indebtedness."

And another spooky illustration in order here:

Now, let's sum this up: after 6 years of 'reforms', deleveraging, special bad loans vehicles set ups, extraordinary legislative and regulatory measures aimed at dealing with loans arrears, waves of corporate and household bankruptcies, a minestrone worth of alphabet soups of various 'Unions' etc etc etc…

• Bad debts pile in Euro area is rising;
• Bad debts pile in Euro area is not matching dynamics in other countries, specifically the economic wasteland of Japan; and 
• The best performing country in the group - Ireland - has the second worst performing banking balance sheet in the group (even after Nama and IBRC are netted out).

Clearly, successful resolution of the crisis is at hand.

8/2/15: Reformed Euro Area Banks... Getting Worse Than 2007 Vintage?..

For all the ECB and EU talk about the need to increase deposits share of banks funding and strengthening the banks balance sheets, the reality is that Euro area banks are

1. Still more reliant on non-deposits finding than their US counterparts; 
2. This reliance on non-deposits funding in Euro area is actually getting bigger, not smaller compared to the pre-crisis levels; and
3. This reliance is facilitated by two factors: slower deleveraging in the banking system in the Euro area, and ECB policy on funding the banks, despite the fact that Euro area banks are operating in demographic environment of older population (with higher share of deposits in their portfolios) than the US system. Note that Japanese system reflects this demographic difference in the 'correct' direction, implying older demographic consistent with lower loans/deposits ratio.

Here's the BIS chart on Banking sector loan-to-deposit and non-core liabilities ratios  showing loan-deposit ratios:

Note: 1)  Weighted average by deposits. 2)  Bank liabilities (excluding equity) minus customer deposits divided by total liabilities. 3) The United States, Japan and Europe (the euro area, the United Kingdom and Switzerland). This ratio measures the degree to which banks finance their assets using non-deposit funding sources.

Source for the chart: http://www.bis.org/statistics/gli/gli_feb15.pdf.

2/1/2015: Irish Banking System: Still Reliant on Non-Deposits Funding

A handy chart from Deutsche Bank Research on sources of funding - focusing on deposits - for euro area banks.

Irish banks are an outlier in the chart, with domestic household and Non-Financial Companies deposits forming second lowest percentage of banks' funding in the entire euro area. As of Q3 2014, Irish banking system remains less deposits-focused and more funded by a combination of other sources, such as the Central Banks, Government deposits and foreign/non-resident deposits.

And the dynamics, post-crisis, are not impressive either: since the onset of the Global Financial Crisis, there has been lots of talk about increasing reliance on deposits for funding banking activities. Ireland's extremely weak banking sector should have been leading this trend. Alas, it does not:

17/11/2014: All the years draining into banking cesspool...

So the tale of European banks deleveraging... record provisions, zero supply of credit for years, scores of devastated borrowers (corporate and personal), record subsidies, record drop in competition, rounds and rounds of 'stress testing' - all passed by virtually all, the Banking Union, the ESM break, forced writedowns in some countries, nationalisations, various LTROs, TLTROs, MROs, ABS, promises, threats, regulatory squeezes ... and the end game 6 years into the crisis?..

Per Bloomberg Brief, the sickest banking system on Planet Earth is... drum roll... Wester European one.

It is only made uglier by all the efforts wasted.

H/T for the chart to Jonathan. 

13/11/2014: Irish Banks: In a Bad League of Their Own

Standard & Poor's report published yesterday (link here) offers a dark view on the French banks, arguing that their capitalisation, based on S&P own metric, puts them into a "weaker position against their European and international peers than according to regulatory ratios".

The S&P looked at the rank order of national banking systems, "resulting from the capital measure that Standard & Poor's Ratings Services uses in its ratings analysis, the risk-adjusted capital (RAC) ratio… According to the latest available comparative data on Dec. 31, 2013, the five French banks (the four mentioned above plus Groupe Crédit Mutuel) had an average RAC ratio of 7.0% versus 7.7% for our top 100 rated banks. …The gap between our in-house measure and the regulatory one (the fully loaded ratio) mostly stems from the banks' internal models for credit risk that we view as less stringent on some asset classes than for some peers. It also results from our stricter treatment than under Basel III of French banks' large insurance subsidiaries."

So in basic terms, S&P used higher quality test of capital buffers. And here are the results for the select sample of European banking systems:

One thing is clear from the above: Ireland's banking system is faring the worst - by a mile - in the sample. In fact, by S&P measure, it is in the league of its own.

28/9/2014: Euro area banks deposits: no sign of significant improvements

Courtesy of @cigolo - a nice chart summing up trends in deposits in Euro area banks from 2009 through Q2 2014:

Italy and Slovenia are two countries that managed to raise the deposit levels in their banking system from Q1 2009. Portugal suffered a decline in deposits off the peak, but stayed above 2009 levels. In every other country sampled, deposits fell from 2009 levels. Note: Ireland too suffered a decline in deposits and in fact, once we control for the reclassifications in deposits, the decline has been more dramatic than the one depicted in the chart (see details here: http://trueeconomics.blogspot.ie/2014/09/2792014-growth-just-not-in-irish.html).

Since the Cypriot bailout, and the introduction of bail-in clause for depositors, Euro area banks deposits stayed basically flat in Italy (with slight decline in trend) and Greece, rose in Slovenia, posted a shallow increase in Portugal, declined in Ireland and Spain, collapsed further in Cyprus. While there was no immediately obvious common trend, deposits pre-Cypriot bailout trend was disrupted or failed to improve in Italy, Slovenia, Cyprus, Portugal, Ireland, Spain and Greece despite numerous efforts to shore up the fallout from the bail-ins under the new systems set up for the European Banking Union.

So much for reformed banking sectors, then. Remember that funding in European banks should be shifting toward more reliance on 'organic' sources, e.g. deposits, than on interbank lending. We are yet to see this happening on any appreciable scale across the 'peripheral' economies.

19/7/2014: Trueconomics Cited in FT

Delighted and proud that FT is quoting the blog on European banks woes: http://www.ft.com/intl/cms/s/0/de39b744-0e61-11e4-a1ae-00144feabdc0.html#axzz37pQsLLmF

July 18, 2014 1:03 pm

Reality check for European banks

By Christopher Thompson and Andrew Bolger

Constantin Gurdgiev at True Economics says while current monetary and investment climates remain supportive of lower yields, markets are starting to show an increasing propensity to react strongly to negative newsflows. Investors’ view of the peripheral states as being strongly correlated in their performance remains in place, especially for Spanish, Portuguese and Greek sovereigns and corporate issuers.

“The markets are jittery and are getting trigger-happy on sell signals as strong rises in bond prices in recent months have resulted in sovereign and corporate debt being overbought by investors,” says Mr Gurdgiev.

Nice birthday present for myself. Thanks, FT!

14/7/2014: Irish Banks are Open for Lending... when no one is looking?

Remember all the Irish banks advertorials in the media about the lending easing they engaged in when it comes to SMEs? The story, as it is being told by the banks, is that our banking system is approving credit to SMEs and that the SMEs just don't apply or don't draw down the loans approved.

Here is IMF chart from today's Euro area survey on the reasons for adverse outcomes of loans applications:

So we have: Irish banks are refusing loans to SMEs at rates second only to Greece. And applications fall short of business expectations at a rate that exceeds that of Greece, so overall, tightness of credit supply to SMEs in Ireland is just as abad as it is in Greece, and worse than in any other 'peripheral' economy.

But never mind, real cost of capital is now back rising in Ireland, so we can expect some additions of grey bars to the above chart too...

All with the blessing of our policymakers who keep talking about higher and higher margins for the banks...

10/2/2014: Six Years to Admit the Obvious? Call in Europe...

There are two things to be said about the latest comments from Euro area's chief banking regulator, Danièle Nouy issued recently (see FT's piece from yesterday: "Let weak banks die, says eurozone super-regulator" for more):

• They are so trivially obvious, that given it took EU 'leaders' 6 years to come up with them, one has to wonder if the EU mandarins have any capacity to supervise banks in the first place, and
• Danièle Nouy deserves praise for speaking to the reality.

Here are the main points of what she said:

1. “One of the biggest lessons of the current crisis is that there is no risk-free asset, so sovereigns are not risk-free assets. That has been demonstrated, so now we have to react.” Correct. But don't expect any change soon. 
2. On the upcoming ECB tests: some banks need to fail for tests to be credible. 
3. “We have to accept that some banks have no future,” she said, parrying speculation that a wave of consolidation could save the currency bloc’s weakest lenders. “We have to let some disappear in an orderly fashion, and not necessarily try to merge them with other institutions.”

You'd think all of the above should be trivial. And you would be right. Which makes the fact that these statements are front-page news in Europe ever so more amazing.

16/1/2014: Fresh Signs of Euro Area Banks Deleveraging Out of Global Growth

For some time now I have been pointing at the ongoing exits by the European banks from the rest of the world (obviously there are some exceptions)... Here's a reminder http://trueeconomics.blogspot.ie/2012/10/13102012-europes-banks-are-now-global.html

Now, more evidence trickling in:

And the process ain't over yet...

24/12/2013: Should Government Do More on Credit Supply? Or Do Better?

We commonly hear about the need for the Government to do something about 'credit supply' to the real economy and 'fixing the bad loans' problem in the banks. Alas, as per the IMF assessment shown in the chart below, Ireland is already well ahead of the majority of its euro area counterparts (save Spain and Slovenia) in terms of policies aimed at supporting supply of credit. And we are way ahead of everyone else in terms of policies that are designed to address the issue of bad loans.

Given having policies ≠ having effective policies or allowing policies on the books to be implemented in the real world. So may be the Government shouldn't be 'doing more' to fix credit supply and demand, but instead 'do better'?

Note: Policies aimed at enhancing credit supply include: fiscal programmes on credit (e.g. credit support schemes, etc), supportive financial regulation, capital markets measures (e.g. funding via state agencies etc), and bank restructuring (that the IMF and the Irish Government often confuse for repairing). Supporting credit demand policies include policies aimed at facilitating corporate debt restructuring and household debt restructuring.

22/11/2013: Euro area banks: leveraged through the nose... still

All you need to know about European banks sickness (it is still raging), the state of European regulations and quality oversight over the banks (it is still crap) and just how far we have travelled from the causes of the crisis (not far at all) in one chart:

European bounds set for the banks are a joke. A bizarre joke. And yet, Europeans call this a 'reform'. And regulators in the countries with completely dysfunctional banks (e.g Ireland) harp on about their banks 'compliance' with or 'meeting' the 'European standards'...

Notice, under the US proposed standards, leverage ratio requirement will be raised to 6% for FDIC-insured banks... meanwhile in Europe, 3% is 'rigorous' and 'robust' and 'safe' and 'never again' level...

Time to smell the roses. Going at the current rate of 'reforms', it will be decades before this European mess is sorted and by then, Europe won't matter to the rest of the world... will not matter at all... backwater with a few nice museums and some statues of the Great Leader Hermit von Frompy strewn across the lovely fields of wheat...

Oh, and if you still think that Newbridge Credit Union is a Big Story - my suggestion is: time for a visit to your friendly head doctor?..

14/11/2013: With banks or without, things are heading for desperate in Italy...

The banks stress tests are coming up and the Euro periphery system is quickly attempting to patch up the massive cracks in the facade. The key one is the continued over-reliance of banks on sovereign-monetary-banking loop of cross-contagion. The banking system weakness is exemplified by Italy: Italian banks are the main buyers of Italian sovereign debt, which in turn means that Italian government stability rests on the banks ability to sustain purchasing, which implies that the ECB (with an interest of shoring up Italian economy) is tied into continuing to provide cheap funding necessary for the Italian banks to sustain purchasing of Italian Government debt… and so on.

Three key facts are clouding this 'stability in contagion' picture:

1. Banks in Italy and elsewhere are not deleveraging fast enough to allow them repay in full the LTROs coming due January and February 2015;
2. Banks in Italy are now fully saturated with italian Government debt, posing threats to future supply of Italian bonds and putting into question the robustness of the banking stress tests; and
3. Italian Government is running out of room to continue rolling over its massive debts.

If all 3 risks play out at the same time or close to each other, things will get testy for the Euro.


Point 1: Banks in the euro zone continue to carry assets that amount to three times the size of the euro area economy. This puts into question the core pillar of banking sector 'reforms' that the ECB needs to see before the banking union (BU) comes into being. The ECB needs to have clarity on quality of assets held by banks and, critically, needs to see robust deleveraging by the banks before th BU can be launched. If either one of these conditions is not fully met, the ECB will be taking over the banking system that is loaded with unknown and unpriced risks.

Per recent ECB data, Banks in the euro zone held EUR29.5 trillion in total assets by the end of 2012. That is down 12% on 2008. Too slow of a pace for a structural deleveraging. Worse, the bulk of the adjustments was back in 2009 and little was done since. Which makes the level of assets problem worse: on top of having too many assets, the system has virtually stopped the process of deleveraging. Knock on effect is that the firming of asset markets in Europe in recent two years was supported by a slowdown in assets disposals by the banks. In turn, this second order effect means that many banks assets on the books are superficially overvalued due to their withholding from the market. Nasty, pesky first and second order effects here.

Worse. Pressure on assets side is not limited to the 'periphery'. German banks held EUR7.6 trillion in total assets at the end of 2012, followed by the French banks with EUR6.8 trillion. Spain and Italy's banking sectors came in distant second and third, with EUR3.9 trillion and EUR2.9 trillion in total assets.

Capital ratios are up to the median Tier 1 ratio rising from 8% in 2008 to 12.7% in 2012. Quality of this capital is, however, subject to the above first and second order effects too - no one knows how much of the equity valuation uplift experienced by the euro area banks in recent months is due to banks reducing the pace of assets deleveraging…


Point 2: Assets quality in some large banking systems is too closely linked to the sovereign bonds markets. Italy is case in point. ECB tests are set to exclude sovereign debt risk exposures, explicitly continuing to price as risk-free sovereign bonds of the peripheral euro area states. But in return for this, the ECB might look into gradually forcing the banks to limit their holdings of sovereign bonds. This would be bad news for Italian banks and the Italian treasury.

The problem starts with a realisation that Italian banks are now primarily a vehicle for rolling over Government debt. Italy's Government debt is over EUR2 trillion. EUR397 billion of that is held by Italian banks. Another EUR200-250 billion can be safely assumed to be held by Italian banks customers who also have borrowings from these banks. Any pressure on the Italian sovereign and the ca EUR600 billion of Italian debt sloshing within the banking system of Italy is at risk.  That puts 20.7 percent of Italian banks assets at a risk play. [Note: by some estimates, Italian banks directly hold around 22% of the total Italian Government debt - close to the above figure of EUR397 billion, but way off compared to Spanish banks which are estimated to be holding 39% of the Spanish Government debt, hence all of the arguments raised in respect of Italy herein also apply to Spain. A mitigating issue for Spain is that it's debt levels are roughly half those of Italy. An exacerbating issue for Spain is that its deficit is second highest in Europe, well ahead of Italain deficit which is relatively benign).

Worse, pressure cooker is now full and been on a boiler for some time. In the wake of LTROs, Italy's banks loaded up on higher-yielding Italian Government debt funded by cheap LTRO funds - Italian banks took EUR255 billion in LTROs funds. In August 2013, Italian banks exposure to Italian Government debt hit EUR397 billion, just shy of the record EUR402 billion in June and double on 2011 levels. I

Either way, with or without explicit ECB pressure, Italian banks have run out of the road to keep purchasing Italian Government debt. Which presents a wee-bit of a problem: Italy needs to raise EUR65 billion in new debt in 2014. Italy is now in the grip of the worst recession since WWII and its debts are rising once again.

Chart below shows that:
1) Italian Sovereign exposures to external lenders declined in the wake of the LTROs, but are back to rising in recent quarters;
2) Italian banks reliance on foreign funding rose during the LTROs period, declined thereafter and is now again rising; while
3) Other (non-financial and non-state) sectors remain leveraged at the levels consistent with late 2006.

Point 3: Overall, Italian Treasury is now competing head on with the banks for foreign lenders cash and Italian corporate sector is being forced to borrow abroad in absence of domestic credit supply. Foreign investors bought almost 2/3rds of the last issue of Italian bonds, but how much of this appetite can be sustained into the future is an open question. Foreign investors currently hold slightly over a third of Italy's debt, or EUR690 billion, down from more than EUR800 billion back in 2011. The Italian Government is now turning to Italian households to mop up the rising supply. Italy issued EUR44 billion worth of inflation-linked BTP Italia bonds with 4 year maturity. As long as inflation stays low, the Government is in the money on these.

Next in line - desperate measures to raise revenues. Per recent reports, there is a proposal working its way through legislative corridors of power to raise tax on multinational on-line companies trading in Italy. The likes of Google, Amazon and Yahoo will be hit with a restriction on advertisers to transact only with on-line companies tax-resident in Italy, per bill tabled by the center-left Democratic Party (PD). The authors estimate EUR1 billion annual yield to the state - a tiny drop in the ocean of Italian government finances, but also a sign of desperation.

9/11/2013: Stress testing zombie banks: Sunday Times, November 3

This is an unedited version of my Sunday Times article from November 3, 2013.


In the marble and mahogany halls of European high finance HQs, the next few months will be filled with the suspense of the preparation for the banks audits.

Much of this excitement will be focused on matters distant to the real economy. Truth is, saddled with zombie banks, and public and private sectors’ debt overhangs, euro area is incapable of generating the growth momentum sufficient to wrestle itself free from the structural crisis it faced since 2008. The latest ECB forecasts for the Euro area economy, released this week, predicted real GDP contraction of 0.4 percent for 2013 and growth of 1 percent in 2014. With these numbers, the end game is the same today as it was two years ago, when previous stress tests were carried out. The system can only be repaired when banks absorb huge losses on unsustainable loans.

New stress tests are unlikely change this. However, the tests are important within the context of the weaker banking systems, such as the Irish one. The reason for this is that the ECB needs to contain the sector risks as it goes about building the European Banking Union, or EBU.

The good news is – there are low- and high-cost options for achieving this containment in Ireland’s case. The bad news is – neither involves any relief on the legacy banks debts necessary to aid our stalled economy. The worse news is – the Government appears to be pushing for exiting the bailout without securing the low cost option, leaving us exposed to the risk of being saddled with the costlier one.


The IMF data suggests that Euro area-wide banks’ losses can be as high as EUR350-400 billion - or just under one third of the total deleveraging that still has to take place in the banks. The ECB needs to have an accurate picture of how much of the above can arise in the countries where banks and Government finances are already strained beyond their ability to cover such losses. The ECB also needs to deliver such estimates without raising public alarms as to the levels of losses still forthcoming.

Taken together, the above two points strongly suggest that in the case of Ireland, the banks will come out of the stress tests with a relatively clean bill of health shaded somewhat by risk-related warnings. Pointing to the latter, the ECB will implicitly or explicitly ask the Irish Government to secure funding sources for dealing with any realization of such risks. Such precautionary funding can only come from either a stand-by credit line with the IMF and/or European stabilization funds, or a commitment to set aside some of the NTMA cash. An NTMA set-aside will cost us the price of issuing new Government debt. This is potentially more than ten times the price of IMF credit line.

In short, Ireland should be using ECB’s concerns over our banking system health to secure a cheaper precautionary line of credit. Judging by this week’s comments from the Government, we are not. One way or the other, it is hard to see how continued uncertainty build up within Irish banks can help our cause in obtaining both a precautionary line of credit and a relief on legacy banks debts.


The ECB concerns about Irish banks are not purely academic. Our banking crisis is far from over.

Consider the latest data on three Pillar Banks: AIB, Bank of Ireland and Permanent tsb, covering the period through H1 2013 courtesy of the IMF and the EU Commission reviews published over recent weeks. On the surface, the three banks are relatively well capitalised with Core Tier 1 capital ratio of 14.1 percent, down on 16.3 percent a year ago. Meanwhile, the deleveraging of the system is proceeding at a reasonable pace, with total average assets declining EUR30.5 billion year on year.

The problem is that little of this deleveraging is down to writedowns of bad loans. This means that high levels of capital on banks balance sheets are primarily due to the extend-and-pretend approach to dealing with nonperforming loans adopted by the banks to-date. All members of the Troika have repeatedly pointed out that Irish banks continue to avoid putting forward long-term sustainable solutions to mortgages arrears and that this approach can eventually lead to amplification of risks over time.

Loans loss provisions are up 11 percent to EUR28.2 billion and non-performing loans are up to EUR56.8 billion. Still, while in H1 2012 non-performing loans accounted for 22.2 percent of all loans held by the banks, at the end of June this year, the figure was 26.6 percent. Non-performing loans are now 35.5 percent in excess of banks’ equity, up from just 4.7 percent a year ago. As a reminder, Irish Exchequer holds 99.8 percent stake in AIB, 99.2 percent share in Ptsb and 15.1 percent stake in Bank of Ireland. This means that should capital buffers fall to regulatory-set limits, further writedowns of loans will mean nullifying the Exchequer stakes in the banks and crystalising full losses carried by the taxpayers.

Continued weaknesses in the solvency positions of the banks are driven primarily by three factors. Firstly, as banks sell or collateralise their better loans their future returns on assets are diminished. The second factor is poor operational performance of the banks. Net losses in the system fell between H1 2012 and H1 2013. However, this still leaves banks reliant on capital drawdowns to fund their non-performing assets. The third factor is the weak performance of banks’ non-core financial assets. Over the last 12 months, Irish banks holdings of securities grew in value at a rate that was about 12-15 times slower than the growth rate in valuations of assets in the international financial markets.

In short, the IMF review presented the picture of the banking sector here that retains all the signs of remaining comatose. This was further confirmed by the EU Commission report this week, and spells trouble for the Irish banks stress tests.

In 2011 recapitalisation of Irish banks, the Central Bank assumed that banks operating profits will total EUR3.9 billion over the 2011-2013. So far the banks are some EUR4.5 billion shy of matching the Central Bank’s rosy projection.

This shortfall comes despite dramatic hikes in interest margins on existent and new loans, decreases in deposit rates, and reductions in operating costs. Compared to H1 2011 when the PCARs were completed, lending rates margins over the ECB base rate have shot up by up to 138 basis points for households and 59 basis points for non-financial companies. Rates paid out on termed deposit have fallen some 103 basis points. As the result, banks net interest margins rose.

On top of that, the funding side of the banks remains problematic. The NTMA is now holding almost half of its cash in the Pillar Banks, superficially boosting their deposits. Private sector deposits continue to trend flat and are declining in some categories. This is before the adverse impacts of Budget 2014 measures, including the Banks levy and higher DIRT rates start to bite.

Behind these balance sheet considerations, the economy and the Government are continuing to put strains on households' ability to repay their loans. This week, AA published analysis of the cost of mortgages carry (the annual cost of financing average family home and associated expenses). According to the report, the direct cost of maintaining an average Irish home purchased prior to the crisis is now running at around EUR 21,940 per annum. Under Budget 2014 provisions, a married couple with two children and combined income of EUR 100,000 will spend one third of their after-tax earnings on funding an average house. In such a setting, any major financial shock, such as birth of another child, loss of employment, extended illness etc., can send the average Celtic Tiger household into arrears.


All of this, means that any honest capital adequacy assessment of the Irish banking system will be an exercise in measuring a litany of risks and uncertainties that define our banks’ operating conditions today and into the foreseeable future. Disclosing such weaknesses in the system will risk exposing Irish banks to renewed markets pressures, including possible failures to roll over maturing debts coming due. It can also impair their ability to continue deleveraging, and fund assets writedowns. On the other hand, leaving these stresses undisclosed risks delaying recognition of losses and exposing us to pressure from the ECB down the line.

Not surprisingly, as the ECB goes into stress tests exercise, it is exerting pressure on Ireland to arrange a stand-alone precautionary line of credit. While it is being presented as a prudential exercise in light of our exit from the bailout, in reality the credit will be there to cushion against any potential losses in the banking system over 2014-2018, before the actual EBU comes into force. Should such losses materialise, the Exchequer will be faced with an unpalatable choice: hit depositors with a bail-in or pony up some more cash for the banks. Having a stand by loans facility arranged prior to exiting the Bailout will help avoid the latter and possibly the former. The cost, however, will be an increase in overall interest charges paid by the State, plus continued strict oversight of our fiscal position by the Troika.

A rock of interest charges and Troika supervision, a hard place of zombiefied banking, and a rising tide of risks are still beckoning Ireland from the other side of the stress tests.

Box-out: 

The latest data from the retail sector released by the CSO this week painted a rather mixed picture of the domestic economy’s fortunes. Controlling for some volatility in the monthly series, Q3 2013 data shows that despite very favourable weather conditions over the July-September 2013, Irish core retail sales (excluding motors sales) fell in volume by some 0.3 percent compared to Q3 2012. On the other hand, there was a 0.6 percent increase in the value of sales over the same period. Currently, the volume of total core retail sales in Ireland sits 4.3 percent below 2005 levels. Non-food sales, excluding motor trades, fuel and bars sales, fell 2.1 percent on 2012 in volume and is up 1.2 percent in value. The inflation effects imply that when it comes to core non-food sales, the volumes of retail trade are now down 22 percent on 2005 levels, while the value of sales is up almost 2 percent. Consumers are still on strike, while retailers are getting only a slight prices relief in the unrelenting crisis.