Commentary on Political Economy

Tuesday, 16 June 2020

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.
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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