Time to wrap a cold towel round the head.
Willem Buiter has been looking at the €860bn war chest the EU and the IMF have amassed to tackle the sovereign debt crisis in the eurozone and the unresolved question of what the cash might actually be used for.
His big fear is the money, in particular the European Financial Stabilisation Fund, ends up being used as a bank recapitalisation funds, in much the same way the Trouble Asset Relief Programme (TARP) was ultimately used to inject capital in the US banking system, not buy illiquid assets.
And this worries Buiter, because €860bn in not nearly enough, especially as sovereigns start drawing down as well.
With banks joining sovereigns as claimants on the EU/IMF Facility (with the funds to the banks possibly routed via the sovereign– funds are fungible but appearances matter) the argument that the Facility is too small and will require at least €2 trillion is strengthened.t
So how might this scenario might play out?
Buiter explains:
These Euro Area banking sector and regulatory/supervisory failures have created a material risk that the sovereign debt crisis now buffeting the region may cause another round of banking crises in the Euro Area, through the effect of low secondary market values of some Euro Area sovereign debt – especially that of the Peripherals (Greece, Spain, Ireland, Portugal and Italy), but before long possibly also that of other countries, including Belgium, Austria and France.
Euro Area banks have (on average) highly concentrated exposures to the debt of the Peripherals, including their sovereign debt (see BIS (2010)). This, itself, represents another example of regulatory and supervisory failure – with Euro Area banks permitted or even encouraged by their regulators to hold large amounts of Euro Area sovereign debt, based on the mistaken assumptions that all Euro Area sovereign debt was more or less the same, and that all of it was safe.
Should the risk of an early restructuring-with-NPV-haircut of the Greek sovereign debt materialise, and should one or more of the other Peripherals end up requiring access to the funds provided by the €440bn EFSF and/or to other parts of the €750bn pot of money put together for EA member states other than Greece, a sharp mark-down (and, in the case of a restructuring, a partial write-off) on the value at which Euro Area banks carry these sovereign debt instruments in their balance sheets looks bound to result. This could weaken the capital positions of many Euro Area banks materially.
With many of these weakened banks unable to attract additional capital from the markets, the only source of capital would be their sovereigns, other sovereigns or the ECB. These ‘other’ sovereign capital contributions could come from a range of sources. One would be Sovereign Wealth Funds (SWFs) and similar public sector asset managers from outside the EU. We expect that, although acquisitions of equity stakes by SWFs from emerging markets (and from Norway) may well occur, political sensitivities will limit their size and scope. Another source would be the EFSF and the other pots of money collectively labeled the EU/IMF Facility in the previous section. The IMF’s contribution to this Facility could not easily be directed into bank recapitalisation, as the Articles of Agreement of the IMF only permit it to supply short-term balance of payments financing, not long-term recapitalisation support and certainly no permanent transfers, current or capital, of any kind.
And if you think that all sounds slightly far-fetched, consider Buiter’s sobering observations about the European banking system:
Euro Area banks therefore need additional capital – a lot of it. This may not be apparent from their ratios of regulatory capital to risk-weighted assets but, in our view, both the numerator and the denominator of this ratio are deeply unreliable. Many EA banks include in their definition of tier-one capital things other than tangible common equity – the only unconditional loss absorber, in our view.
In addition, we think the risk weightings are deeply flawed (triple-A rated sovereign debt is assigned a zero risk weighting, for instance) and depend in part on non-verifiable model-based information provided by the banks themselves. Gross leverage ratios provide, in our view, a less distorted picture of the default risk of banks. It is true that, in principle, higher leverage can be achieved without increasing risk, simply by adding matching assets and liabilities to the balance sheet. In the real world, however, there is but one reason banks take on additional leverage: that is, to assume additional risk
In addition to the excessive leverage of many EA banks, there is the longstanding problem of their apparent lack of transparency. Many of them continue to avoid, through a variety of accounting measures, allowed by changes in rules and conventions introduced since the start of the financial crisis by the International Accounting Standards Board (IASB), the marking to market of many illiquid and risky assets.
And Buiter doesn’t think the current round of stress tests will do anything to address that because they won’t ask the right questions:
The stress tests are unlikely to include questions like: how would the solvency position of your bank be affected by a restructuring, with a 30 percent NPV haircut, of the sovereign debt of (1) Greece; (2) Greece and Spain; (3) Greece, Spain and Ireland; (4) Greece, Spain, Ireland and Portugal; and (4) Greece, Spain, Ireland, Portugal and Italy. In the absence of stress tests that include scenarios involving multiple sovereign defaults, we think it is difficult to view even the new exercise as a major confidence-boosting event.
Quite.
Related links:
Some stresstestimates – FT Alphaville
Give us the figures on Europe’s toxic banks – Wolfgang Münchau, FT
Sovereigns not included? More on Europe’s stress tests – FT Alphaville
Must Europe’s stress tests fail in order to succeed? – FT Alphaville