The European Cental Bank’s LTOR Initiative – furthering a deadly embrace?

To say the entire world has been fixated on the twin woes of a weak European banking sector and faltering sovereign fiscal situations will be stating the obvious. However, there is great justification for this fixation because of the extraordinarily tight connection between the economic fortunes of most European countries and their banks. Much has being made of the “too big to fail” issue as it concerns large American universal banks such as Bank of America, Citigroup, JP Morgan etc. While these institutions are large and have gotten larger in the recent past, their impact on the US economy seems really benign when compared to the impact their European counterparts have on their host countries.

Throwing out some numbers, the weakened Dexia Bank’s assets account for ~150% of host country Belgium’s GDP, RBS’ assets exceed 100% of UK’s GDP, BNP Paribas’ asset base is up to 100% of France’s GDP and so on. While a big driver of these numbers come from the far more international activities of European banks, it does not detract from the fact that in the vast majority of European countries we have less than 5 banks controlling substantially all of the banking system’s deposits and assets. French banking is basically controlled by BNP Paribas, Credit Agricole & Societe Generale, Unicredit & Intesa Sanpaolo have that distinction in Italy while Deutsche Bank has a kind of overwhelming influence on German finance that no American bank even comes close to having. If you couple this dominance with the fact that Europe has a more bank-centric financing system than the US, then the power of these banks become more glaring. Over the past couple of decades a shadow banking system, fuelled by securitization, has emerged in the United States to challenge the dominance of banks in extending credit to the economy. This has been far less developed in Europe with banks on the continent been more likely to hold assets on their books.

This has become apparent in the past couple of years with European nations basically turning a banking crisis into a fiscal one. Some of the fiscal problems currently ripping through Europe can be traced to the massive costs incurred by these nations as they tried to bail out their banks and ended up breaking their fiscal purses. One can easily link, to a non-trivial extent, the Irish fiscal crisis to the cost faced in bailing out such large lenders such as the Allied Irish Bank and the Bank of Ireland. As these banks have stabilized, the true costs of the (admittedly necessary) bailouts have become apparent as they are reflected in the higher borrowing costs of marginal European nation.

This now brings me to the potential danger in the ECB’s latest plan to shore up the European banking system through the recently introduced Longer Term Refinancing Operation (LTRO). Theoretically, the aim is to provide a liquidity backstop to European banks as they seek to jumpstart lending to the economy. I am however somewhat skeptical of LTRO’s benefits due to the potential for the carry trade. The December round of approximately EUR 500 Billion 3-year LTRO funds disbursed have an interest rate of 1%, while Italian, Irish and Portuguese government 3-year notes yield 3.9%, 4.5% and 1.91% respectively. From these numbers one can easily see a situation where the banks take money from ECB and just plough them into purchases of European sovereign bonds. For example, Intesa Sanpaolo (the big Italian bank) participated in the LTRO funding window up to the tune of EUR 24 Billion. Since the bank has an average Net Interest Margin (NIM) of ~1.6%, borrowing from the ECB and buying Italian bonds will yield a spread of 2.9% (almost double its NIM on loans). And to crown the good deal, due to banking regulations its purchase of these bonds will be deemed riskless and it will not need to set aside any capital for potential losses.

If this happens across the banking sector, we will end up in a scenario where bank holdings of sovereign debt increases in an era of increasing fiscal instability. If there are defaults on these debt holdings, the banks will suffer large losses and will have to be bailed out by the governments whose fiscal situations will then worsen as a result. In essence, this move may be locking European banks and sovereigns in a tighter deadly embrace.

I hope that the doomsday scenario does not happen, but I see a reason to be skeptical