Europe banks overexposed to domestic debt

December 23, 2013 10:20 am

Europe banks overexposed to domestic debt

By Christopher Thompson

The economic fates of European governments and financial institutions are set to become ever more intertwined next year despite concerns about the rise of a potentially destabilising “sovereign-bank” nexus.At present Europe’s banks are more exposed to their domestic government bonds than at any time since the eurozone crisis started according to figures from the European Central Bank – despite pledges by European authorities to break the link.

However, that exposure is poised to increase as eurozone banks trim their balance sheets, cutting back on lending and investing their surplus deposits in government bonds, which are perceived as safer assets according to Huw van Steenis, a senior bank analyst at Morgan Stanley.

“As lending shrinks and deposits grow banks will invest the surplus in treasuries,” he said. “Banks’ deleveraging drives sovereign bond holdings higher – as a result Spanish and Italian banks in particular will own more not less sovereign bonds by the end 2014 after the [European Banking Authority’s] banks stress tests.”

Analysts say the sovereign-bank nexus could create a dangerous feedback cycle in which banks with large holdings of government bonds are affected by volatility in sovereign debt markets while governments in turn are jeopardised by local banks.

“The feedback loop between banks and sovereigns is a concerning one – look at [what happened] in Iceland, Ireland and Cyprus,” added Mr van Steenis.

Over the two years from October 2011, just before the ECB began to pump in over €1tn into Europe’s financial system to stave off a liquidity crisis, Spanish banks increased government bond holdings as a proportion of their total assets to 9.4 per cent from 5 per cent and Italian banks to 10.3 per cent from 6.4 per cent. In Portugal the proportion rose to 7.8 per cent from 4.6 per cent and in Slovenia to 10 per cent from 7.8 per cent.

The pattern is not confined to the periphery. German banks have boosted their holdings of sovereign bonds to 4.5 per cent from 3.8 per cent over the same period while banks in France and Austria have increased their holdings by about one per cent respectively. The majority of the sovereign holdings consist of banks’ own domestic government bonds, according to analysts.

“Aggregate [sovereign] holdings have been going up, and I think they will not decline substantially even with the potential threat to banks of a sovereign-adjusted risk weight in the [ECB’s] asset quality review,” said Alberto Gallo, senior credit analyst at Royal Bank of Scotland.

“The reason why banks are not selling is they need more time and more capital . . . without sovereign [holdings], many mid-tier banks in the periphery would have negative or flat net earnings.”

The figures come ahead of key bank stress tests next year in which European authorities have yet to finalise how to treat banks’ sovereign holdings. At present sovereign holdings are not risk weighted under the European Union’s CRD IV rules.

Between the end of 2011 and the beginning of 2012 the ECB pumped over €1tn of cheap money into the region’s financial system under its long-term refinancing operation. Many banks who wanted to earn an easy “carry trade” took the cheap ECB loans and invested them in higher-yielding bonds issued by their national governments.