The safety-net frays
Feb 11th 2010 BERLIN
From The Economist print edition
Governments used to worry about their banks. Now the reverse is also true
Illustration by S. Kambayashi
A SENIOR HSBC executive reminisces fondly about the day he was parachuted into Latin America, a decade or so ago, to help run a recently purchased but troubled local bank. As he arrived he passed people protesting against the acquisition, some of whom were being carried about in coffins. For a moment he wondered whether that would end up being his fate.
Until recently bankers’ tales of derring-do during the Asian, Latin American and Russian debt crises were kept for after-dinner drinks. Now, many of these old emerging-markets hands are in high demand during the day, as banks and investors ponder the potential effects of the euro zone’s debt crisis. “Sovereign risk has supplanted regulatory risk as the primary focus of bank bondholders,” says Jonathan Glionna at Barclays Capital.
The prospects of a full-blown default by a European government still seem remote, especially given rising talk of a bail-out for Greece. Yet were it to occur, the consequences could be nasty. Jörg Krämer of Commerzbank notes that the Greek government’s outstanding debt securities of €290 billion ($398 billion) dwarf the amount Lehman Brothers owed bondholders at the time of its collapse.
Greek banks would be most exposed to the fallout. They hold about €39 billion of government debt, roughly equivalent to the amount of capital they have. There are rumours that Greek banks have also been keen sellers of credit-default swaps on sovereign Greek debt, in effect doubling up on their exposure to a debt crisis.
Commerzbank reckons that about 60% of the Greek government bonds issued over the past few years were sold to non-Greek European buyers, half of whom may have been banks. Any restructuring of Greek, or other euro-zone, debt could result in European banks having to take “massive write-offs”, says Mr Krämer. American banks are less exposed to wobbly euro-zone countries, but the numbers are still pretty big. Barclays Capital reckons that the ten biggest American banks have total exposures to Ireland, Portugal, Spain and Greece of $176 billion.
The bigger concern, however, is not banks’ direct exposure to government bonds, which average just 5% of euro-zone banks’ assets, but the impact on their financing. The costs of funding for banks on Europe’s periphery are rising in tandem with the allegedly “risk-free” benchmark rates on the bonds of troubled European governments. Steep downgrades of the sovereign-debt ratings of countries such as Portugal, Greece and Ireland would probably translate into immediate rating cuts for their banks, as well as higher capital charges on banks’ debt holdings and bigger haircuts when using this debt as collateral. Regulators are busy designing rules forcing banks to hold more government bonds on the assumption that they are the most liquid assets in a crisis. That premise may not hold for every country’s debt.
A second concern is that the premium that investors demand for holding bank debt may also widen above the benchmark “risk-free” rate. “If governments are either less willing, because of competing pressures on budgets, or are unable to provide support then that could have a material impact on bank ratings,” says Johannes Wassenberg of Moody’s, a rating agency. The consequences of even small changes in a bank’s borrowing costs can be extreme. JPMorgan, an investment bank, reckons that an increase of just 0.2 percentage points in the borrowing costs of British banks such as Lloyds Banking Group and Royal Bank of Scotland would trim their earnings by 8-11% next year, assuming they could not immediately pass these costs on to customers.
Fearsome as the prospects of sovereign default are, bankers also fret about the impact of avoiding one. In countries such as Portugal, Greece and Ireland, where big government deficits have to be cut back, loan growth is likely to decline and bad loans to increase as economies slow. Sovereign risk is out of the bottle. There is no easy way of putting it back in.
Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.
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