Banks are unlikely to come to the aid of debt-ridden eurozone countries, with many planning to ignore political pressure to use cheap money from the European Central Bank to fund purchases of sovereign bonds.
With eurozone governments needing to sell almost €80bn of fresh debt in January alone and bond yields rising by the day, the stand-off between policymakers and banks could turn Europe’s slow-burning debt crisis into a full-scale conflagration in the New Year.
Burned by Greek losses, and under the scrutiny of shareholders, banks have slashed their exposure to weaker European sovereigns over recent months. Senior bankers say they will cut further, despite pressure to use newly available, longer-term ECB loans to buy government debt as part of an officially-sanctioned carry trade.
“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”
That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.
Such attitudes will come as a major blow to European policymakers, who had been hoping banks would use ECB money to profit from the carry trade, helping governments in the process. “Each state can turn to its banks, which will have liquidity at their disposal,” French President Nicolas Sarkozy said after last week’s summit of leaders.
“Banks need this liquidity to get them through the wall of refinancing they are facing next year. That’s where the money is going to go”
Under the ECB’s new long-term refinancing operations starting on December 21, banks will be allowed to borrow money against certain assets on a three-year basis, paying just 1% per annum. They could then buy Italian 10-year bonds yielding more than 7%, and pocket the difference.
Debts come due
But rather than use money raised via the ECB to buy government bonds, bankers say that they are more likely to use the funds to pay off their own debts.
“I can’t think for a moment why anyone would want to [buy eurozone government debt],” said the head of capital markets at one European bank that is also reducing its exposure to eurozone sovereign bonds. “Everyone is trying to protect capital. It’s counter-intuitive. It would be digging a deeper hole for yourself.”
Indeed, the European banking industry collectively needs to pay back or refinance about €650bn of liabilities next year – Lloyds, UniCredit, BNP Paribas, RBS and HSBC face the most, each having €30bn or more of instruments maturing, according to estimates from Nomura.
With bank debts coming due and most firms unable to raise fresh funds in bond markets – which remain largely closed – bankers say it is much more prudent to use ECB loans to pay off their own creditors rather than speculate that European governments pay back all their debt.
“Banks need this liquidity to get them through the wall of refinancing they are facing next year,” said the capital markets head. “That’s where the money is going to go. Banks need to deleverage rather than re-leverage. It’s just wishful thinking that they will pile back into government bonds.”
Further reductions in government bond holdings are likely to continue, say bankers, robbing European capitals of an important source of credit and potentially pushing yields higher.
European Banking Authority data show that the 65 banks that were subject to EBA stress tested collectively shed €39.4bn of Italian bond holdings in the first nine months of the year. They reduced Spanish government debt holdings €12.7bn in the same period. More recent figures are not available.
BNP Paribas saw one of the biggest drops in its peripheral bond holdings during that period. The gross value of its Italian holdings dropped €5.2bn – equivalent to about a fifth – while its Spanish holdings were €490m – or about 10% – lower. Most of the declines were in longer-dated bond holdings, indicating that they weren’t due to redemptions.
Foreign banks were the biggest sellers of both Italian and Spanish government debt in the nine-month period. The trend marks the reversal of a previous decade-long carry trade that saw foreign banks buy peripheral European debt in droves because of the extra yield.
Perhaps surprisingly, not everyone is selling. Spanish banks added to their domestic government bond holdings during the period. BBVA, Banco Santander, Bankia and Banco Popular together increased their gross holdings of Spanish government debt by €7.6bn in the first nine months of the year.
“We are not convinced that most European banks will use the LTRO to buy a substantial amount of government bonds,” wrote Morgan Stanley analysts. “Although we think mid-cap banks will be more desirous [of doing so] than others and [that] could generate reasonable demand in Italy and Spain.”
Not enough buyers
Heavy selling from foreign banks, however, has outweighed domestic buying and that dynamic is unlikely to change soon. Bankers say foreign lenders are not willing to take the risk associated with holding peripheral government debt for long periods. Protection via CDS is costly and its value is in question because it failed to trigger when private Greek debt-holders were recently bailed in.
“Leaving the sovereign exposure unhedged presents difficulties even for domestic banks,” added the Morgan Stanley analysts. “So the carry trade even for domestic banks implies that the banks need to hold excess capital to do the trade.”
Bond sales in the New Year will be a big test of whether the strategy will work. In the first quarter alone, Italy plans to sell around €50bn in fresh debt and Spain €21bn. If Rome is unable to find buyers for its debt, that could jeopardise the payment of €28bn of maturing debt on February 1 and a further €16bn on March 1. Spain doesn’t have any major redemptions in the first quarter.
“It’s potentially going to be very very challenging,” added one debt banker who is involved in the New Year sovereign debt sales.
“While steps are being taken, the crisis is far from over,” added Mark Schofield, an analyst at Citigroup. “There is ample scope for rewidening as the market gets ahead of itself and as each bubble of optimism is pricked by reality. At the risk of sounding like a broken record, things will get worse before they get better.”