UBS analysts Alastair Ryan and John-Paul Crutchley — of European Central Bank (ECB) as ‘liquidity monster’ fame — are on form in their latest eurozone banking note.
Their theme: The ‘tipping point’ at which banks’ reliance on ECB funding becomes a problem for markets.
Their (refreshingly direct) answer: at about 8 -10 per cent of bank assets.
Here’s what they say:
Usage of ECB facilities by the banks is already over €800 billion, highlighted in Chart 3. We believe the current stress in financial markets is likely to drive this level up significantly. This ECB expansion contrasts with the US and UK, where banks and governments are increasingly able to fund themselves in the private markets. Later in this report, we detail the levels of intervention by the authorities in the various markets but, in summary, Table 1 highlights that the ECB is becoming more involved on every front as its peers elsewhere are running down their exceptional programmes.
Banks use that ECB liquidity in a few ways, but one of the most significant is as cheap funding for a type of carry trade. That is, they use (low rate) commercial paper or the ECB repo funds to buy (higher-yielding) government bonds.
And that’s where the trouble comes in:
We believe an expansion of the carry trade could prove challenging for bank valuations under certain circumstances. We do not see an inability to finance government debt; nor a compulsion for banks from a liquidity perspective to exit portfolios. The ECB’s willingness to fund the positions removes these risks. However, in the event that a bank’s wholesale funding becomes outsized relative to its deposit base or, especially, in the event that challenging markets lead the bank to use ECB repo to fund the portfolio, the market’s assessment of the banks concerned could well meet a ‘tipping point’ beyond which the independence of the bank over time is questioned.
The Greeks, UBS say, are a perfect example of the ‘tipping point’ of over-reliance.
At the start of last year, after wholesale markets dried up, Greece’s central bank said it was fine with banks tapping ECB facilities for things like term maturities. And then look what happened:
The banks rapidly embraced the ECB and, once using it, felt increasingly comfortable with higher levels of exposure. This generated a virtuous circle, as the banks built up carry trades, in Greek government debt. This source of demand for the government’s paper kept yields relatively low, while the notional cost of funding allowed the carry trade to enhance banks’ earnings. For several months, this led to rising share prices and muted concerns over the government’s ability to finance its deficit.
But then, late last year, with those sovereign credit rating downgrades on the horizon, the Greek financial system hit a brick wall:
Towards the end of 2009, the market began to question the sustainability of this. Several banks had ECB funding close to 10% of their balance sheet by this time. The banks became reluctant to keep expanding their balance sheets as the market became unwilling to pay them for the incremental earnings generated. Demand for incremental Greek government debt therefore declined at the same time as disclosures from the incoming government laid bare a higher deficit than previously believed. This quickly led to a challenging government bond market.
And we all know what happened after that.
The danger then is that by pouring into this duration risk-heavy carry trade, banks risk the market’s ire, nevermind exposure to abrupt interest rate, monetary policy (QE), or funding changes.
According to the UBS analysts there’s one eurozone financial system that’s now particularly exposed to this risk:
The Spanish system is the most exposed, because it has thus far recapitalised or restructured little. The banks have been confident in putting on the carry trade, to offset declining domestic margins and typically funded in the commercial paper market, because of the ECB’s willingness to repo the assets in the event of the commercial market closing.
And some Spanish banking stats that should make anyone pause for thought:
The smaller Spanish banks are now making up to 12% of [Net Interest Income] from this [carry] trade in its broadest sense (including trading books, etc.); the larger (more diversified) banks 6-10%. We note that with the incremental costs associated with the trade almost zero, this level of income would typically add 20% to reported profits at the larger banks and close to 40% at the smaller banks . . . In the case of the Spanish banks, we believe both the size and durations of their Treasury/ALCO/trading portfolios (they should be looked at collectively) have grown significantly in recent quarters. This has not reflected proportional increases in cost-free deposits. Therefore, the increased trading portfolios are using up wholesale funding capacity for the banks, other than those being funded directly from the ECB, such as Banesto has discussed for at least €2.5 billion of its book. In good times this is not problematic but in a more stressed environment we believe gross funding requirements are an issue that potentially all banks face. Given that for these portfolios to make sense from a yield pickup, they would typically be funded in the commercial paper markets, increased funding strains would be felt very quickly.
Spanish banks, shield thine eyes.
Related links:
Onwards, upwards, forever, European liquidity - FT Alphaville
The fight for deposits in Spain - FT Alphaville
Carry-ing on in Spain – FT Alphaville
How do you say vicious circle in Greek? – FT Alphaville