The intrinsic (intractable?) bank bid for sovereign debt | FT Alphaville

The intrinsic (intractable?) bank bid for sovereign debt

There are a few ways to greet the news that eurozone banks are more exposed to their sovereigns than ever. One’s to note that this just means more human shields to deal with (somehow) in a restructuring…

Another’s to argue that this is the euro’s fragmentation quietly winning out in the longer term, over actions by the ECB. After all, who isn’t holding these bonds in place of the domestic banks.

Another still however is the observation that the OMT’s “reduction in sovereign risk premia” might help “improving the balance sheet of sovereign bondholders (in particular banks),” which is what Benoît Cœuré of the ECB said last week. Emphasis ours.

That’s before we even get to the capital treatment of sovereign bonds in Euroland: not just CRD and zero weighting for own sovereign risk, but more recently, moves to ‘filter’ available-for-sale holdings of government bonds. The beat goes on.

There’s a lot, in short. But the point is if it’s rational for banks to continue behaving this way.

So it’s interesting to read these points made last week by Deutsche analysts Gilles Moec and Mark Wall, updating an analysis of the same issue which they did four years ago… it’s about “intrinsic allocation preference”:

The notion that government bonds are lower risk is not just a regulatory convention. That governments – even in the struggling countries – are more solid than private sector issuers is even truer in the new European context: since the beginning of the crisis, only sovereign bond markets – via the ESM and the ECB – have been directly supported by the European solidarity mechanisms. No such help came for private sector assets (with the exception, briefly, of banks’ covered bonds)…

Indeed, the impact of the particularly deteriorated economic conditions on loan delinquency is compounded by the fact that each 1% of NPL has a larger impact on the overall balance sheets than in Germany and France. This creates another incentive for Southern European banks to “cover” their domestic private sector exposure with “risk-free assets”, on top of the extra incentive to buy government bonds created by the particularly large curve steepening, itself a consequence of the worsening in debt dynamics triggered by the recession and subsequent downward revision in market views of potential GDP.

Which is why it’s telling to look not so much at holdings of sovereign bonds in comparison to total assets, but specifically bonds versus banks’ private-sector loans– as in Deutsche’s chart above.

One optimistic implication of the role of rubbish economic conditions here is that the bank bid for sovereign debt will simply ‘normalise’ when a eurozone recovery starts to take hold this time. As Deutsche note, this has happened before, in the years leading up to the euro’s creation, when banks’ purchases of government bonds levelled off.

On the other hand — the market was well on its way at that point to pricing Greek risk within mere basis points of France, and we’re probably not going back to that. Some closing thoughts from Deutsche:

The sheer level of accumulated private debt is much higher today, consistent with a higher solvency risk. Since 2003 (the starting point of the ECB data on consolidated national banking balance sheets) the debt of the corporate sector has increased by 50% of GDP in Spain (in spite of the recent deleveraging). Even in Italy where the absolute level of corporate debt remains low, the increase over the last 10 years has been significant (+25% of GDP).

This time there is no obvious “jolt” to the system in sight. After the mid-1990s, Europe went through a period of massive spread compression and decline in the absolute level of interest rates triggered by the prospect and then the completion of the monetary union project. Today the level of interest rate can hardly go lower in the core Euro area, and with the beginning of a global normalization in interest rates, the scope for a decline in interest rates in the periphery is limited, even if spreads stabilize…

Related links:
Cyprus, where the vicious circle stopped – FT Alphaville
Stop encouraging banks to buy government debt – FT
Risk management in the face of risky sovereign debt - BIS
Europe: Saved by the genius of Spanish bankers – Pawelmorski