Europe
Is in Danger of Another Sovereign Debt Doom Loop
ECB stimulus will encourage banks to hold more national bonds.
This is potentially dangerous for the euro zone, as we saw in 2012.
By
and
June 16, 2020, 3:30 PM
GMT+10
The European Union has
been relaxing its
rule book for banks — painstakingly built up in the decade or so since the
financial crisis — as it tries to manage the impact of coronavirus.
Unfortunately, the move might create big problems if economic activity fails to
recover.
That’s
because the regulations are being eased just as the European Central
Bank is about to inject a huge amount of liquidity into the euro-zone
monetary system. This will lead almost certainly to commercial lenders
acquiring more sovereign debt through what are known as “carry
trades” — where they borrow cheaply from the ECB and seek to make a
safe profit by buying investment-grade bonds that yield more than their
borrowing cost.
So banks
will be snapping up more debt from their national governments, potentially
creating an infernal “doom loop,” where a bank will struggle if the value of
its government bondholdings plunge in a market rout (say if the economy tanks
again) — and the lender’s and the sovereign’s fate would be locked together.
This became a systemic threat early in the last decade, stoking the 2012
euro crisis.
Europe’s
financial response to the pandemic has been admirable, and it makes sense to
loosen banking rules to ensure the wheels of the economy can turn
again. But the latest relaxation is risky. It will temporarily free
lenders from taking a hit to their capital ratios should their portfolios of
government debt shrink in value, in essence removing part of the requirements
to mark-to-market (in other words, mark down any market losses).
This is a
bold move as the ECB is simultaneously pump-priming the banking sector with as
much liquidity as it wants, to spend however it wants. The past three months
have already seen a record jump of 200 billion euros ($225 billion) in EU
banks’ holdings of euro sovereign debt, according to analysts from
Jefferies International Ltd. Looser capital rules will just add to the attraction.
Doom Loop Rising
Italian banks hold close to
a record amount of government debt
Source: Bloomberg
This
week’s main event will be a new round of ultra-cheap ECB loans to banks, known
as targeted long-term refinancing operations (TLTROs), with rates as generous
as minus 100 basis points. The central bank is literally paying banks to
borrow. Frederik Ducrozet, a strategist at Pictet Wealth Management, estimates
that lenders will take up 1.2 trillion euros. Inevitably some will be
parked in liquid government debt, at least in the short term.
Much of this extra money will end up being used by bankers in those
carry trades. In this case, banks will borrow at -1% in the TLTRO scheme, then
invest in government bonds and investment-grade corporate debt that
provide a juicy return. This might improve lackluster bank
profitability, but at what cost if it means lenders are then holding too much
government debt?
It’s one
thing for the ECB to own as much as 450 billion euros of Italian government
bonds, and quite another for commercial lenders to be so exposed to one
nation. Italy’s Intesa Sanpaolo SpA is already that country’s second-largest
creditor, with about 100 billion euros of its national debt. Piling yet
more government borrowings into the Italian banking system, which holds a
higher percentage of its country’s bonds than any other euro-area nation, might
not be a good idea.
The impetus to push more money into the finance system and to
encourage government borrowing is entirely understandable right
now. But it risks leaving the euro zone exposed again to its Achilles heel
of having a banking system that funds sovereign debt. This may all be
necessary to reinvigorate the European economy but danger lurks.
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