James Saft, Reuters Columnist
Official funding has a nasty habit of driving away free market money, as Europe’s banks may yet discover. Struck last year by a lenders strike, Europe’s banks have seen their immediate funding fears eased in recent months by a host of measures, such as cheap funding from the European Central Bank and a related boom in the issuance of “covered” bonds, those secured by bank assets.
Unfortunately, you can only “cover” so many bonds before other creditors begin to wonder what assets they could get their hands on
These forces have eased fears of bank failures but ironically have made banks less and less attractive institutions to which to lend.
Think of it almost as an analog to Gresham’s Law, the famed observation that bad money drives out good, as the introduction of a new, debased currency with less precious metal content causes the old purer stuff to disappear into people’s mattresses. Who’d spend a silver coin when there are so many made of nickel and copper of the same legal value?
In the same way, who will lend to a European bank when so many of its assets are pledged elsewhere, either to secured bonds or pledged in one way or another to powerful official creditors like the ECB? The bad, or faux, funding is driving out the good.
European banks are a lot less likely to fail than they were three months ago, but you, as a creditor, will find there is a lot less money you can recover if for whatever reason they do. The likely result: a spiral of increased and institutionalised reliance on official credit, which will increasingly drive away free market credit.
“Bondholders face increasing subordination from this balance sheet encumbrance, reinforced by depositor preference laws (in some countries) and imminent legislation on bail-in bonds,” analysts at Barclays Bank led by Simon Samuels wrote in a note to clients.
“Combining these factors suggests that unsecured funding costs for banks will remain high – potentially too high for some business models to make economic sense. If funding costs can’t come down to economic levels, banks will either have to look for other sources of funding, or shrink. Alternative funding sources could include further covered bond issuance (encumbering balance sheets further) or aggressive growth of deposit franchises (thereby shrinking lending margins).”
The key concept here is encumbrance, the pledging of an asset on a bank’s balance sheet to a specific creditor or class of creditors. When the senior bank debt market froze last year, issuance by eurozone banks of covered bonds rocketed. Covered bonds are thought safer because the amounts lent are secured by a pool of bank assets which bondholders have first call on in the event of default.
Unfortunately, you can only “cover” so many bonds before other creditors begin to wonder what assets they could get their hands on.
LTRO-DRIVEN DEMAND
Covered bonds accounted for 40% of commercial bank debt issuance in the eurozone last year, leaving several banking systems with over 15% of their assets encumbered, notably Spain at about 24% and Ireland and Portugal approaching 20%.
Much of this was driven by a desire to get acceptable assets to pledge with the ECB for good old-fashioned cash at super-low rates of interest, cash which can in turn be reinvested in a higher-yielding bond, like perhaps some Portuguese or Spanish government bonds.
This, of course, is where the move to make the ECB, eurozone central banks and the European Investment Bank senior to other lenders to sovereigns comes in. Not only will an un-secured creditor to a eurozone bank find that there are precious few assets to go after freely in the event of a default, he may well find the balance sheet even more stuffed with sovereign debt which is itself “encumbered” by the precedence which official creditors will take if those countries need to renegotiate their debts.
The truth is that Europe has rescued its banks, as a government in a fiat money system always can, but in doing so has further crippled their ability to stand without assistance. This brings up ugly decisions and difficult negotiations with Europe’s international peers.
Should Europe keep bank funding so cheap that pressure is removed to shrink balance sheets? That will help ease the credit crunch but it is also a key part of how Japan ended up where it is today, all these growth-less years down the road.
It seems obvious that having given the banking system about €1 trillion in three-year loans, the LTRO will now have to become a standing feature for some time to come.
All of this may just beat the alternative of a mass bank run in the eurozone, but an institutionalised system in which banks depend utterly on official support, supporting in turn those governments by holding their bonds, is one which, to put it kindly, cannot go on forever.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)