By Gareth Gore
LONDON (IFR) - Major European banks doubled their exposure to government debt in the two years running up to the latest stress tests despite a worsening in the economic fundamentals of many countries, according to an IFR analysis of European Banking Authority data.
At a time when lending to the private sector plummeted, these banks continued to extend credit to struggling governments, with many re-entering - and even doubling down on - the same kinds of carry trades that some abandoned in the throes of the eurozone crisis in 2011.
BPCE, Credit Agricole, Societe Generale and HSBC doubled their holdings of French government debt, for example, adding €81bn of bonds and loans to their books. Italy's four biggest banks added €53bn of domestic public debt, while mid-tier Spanish banks also lent more to Madrid.
"The carry trade is still too tempting for many banks, even those that wanted to de-link from sovereigns not that long ago," said Nikolaos Panigirtzoglou, a strategist at JP Morgan, on hearing of the IFR analysis. "They see it as an easy way to boost profits and are perhaps complacent to debt sustainability risk on some countries."
The analysis takes the sovereign exposures of banks at the end of last December, when the EBA took a snapshot of bank balance sheets for its most recent stress tests, and compares them to holdings in September 2011, the last EBA examination of banks' balance sheets before the European Central Bank injected €1trn of liquidity into the system via its longer-term refinancing operations.
BPCE has the biggest exposure of any bank monitored by the EBA in the exercise to a single eurozone sovereign, with its French public debt position almost €83 billion at the end of December, according to the latest stress test data. That is almost twice the €42.5 billion position it held in September 2011.
Credit Agricole doubled its French debt exposure to €50.7 billion from €25.1 billion previously, while Societe Generale's exposure grew to €35.4 billion from €20.4 billion. HSBC now has the biggest exposure of any foreign bank to French public debt at €35.2 billion, up from €14.1 billion.
Italian banks Intesa Sanpaolo, UniCredit, Banca Monte dei Paschi di Siena and UBI Banca together added €53bn of Italian public debt between September 2011 and last December. Intesa Sanpaolo has €77.3bn of exposure, and UniCredit €56.7bn. Monte dei Paschi failed the latest stress tests and was ordered to raise €2.1 billion in fresh capital, sparking a 22% decline in its share price on Monday.
Meanwhile in Spain, while major lenders BBVA and Banco Santander have cut their exposure to domestic public debt, mid-tier banks including La Caixa, Bankia and Banco de Sabadell all increased their holdings – with some of the smaller institutions doubling their positions.
And though the EBA data only give a snapshot of bank positions in December, recent ECB figures illustrate that the problem has worsened since then.
The sovereign bond portfolios of eurozone banks reached a record €2.4 trillion in September, according to the ECB. That is 30% higher than in 2011, accounting for 7.7% of all assets owned by the entire eurozone banking system.
HAPPY ENOUGH
These portfolio purchases have helped bring down sovereign bond yields and eased pressure on debt-riddled governments, which in turn convinced some regulators to turn a blind eye to the rapid accumulation of government debt. Buying from banks helped bring down Italian and Spanish 10-year bond yields to record lows of 2.3% and 2% this year. Both were trading above 7% just two years ago.
Banks are of course also happy to buy government debt, because such positions can be taken without holding regulatory capital, unlike other loans which must have reserves held against them. Banks with capital constraints thus can borrow cheaply from the ECB – and reap the profits of the trade without the need to muster additional capital.
"The carry trade is an old habit many banks can't kick," said Alberto Gallo, a credit strategist at RBS. "A lot of the European banks – even ones that passed the stress tests – are capital-constrained, so the returns from non capital-absorbing sovereign debt look more attractive than loans."
"It is much trickier to lend to the real economy because regulatory hurdles are greater, making it less appealing than carry trades," said JP Morgan's Panigirtzoglou. "Risk weightings are zero for government bonds and can be as high as 100% for other types of lending."
The prospect of further quantitative easing from the ECB, which is likely to come in the form of sovereign bond purchases, as well as a pledge from President Mario Draghi to "do whatever it takes" to save the eurozone have left many banks convinced exposure to government bonds is safe and can be offloaded or run down over time, say analysts.
NOT EVERYONE
Still, some banks are reducing their exposures. Deutsche Bank and BNP Paribas both took heavy losses after Greece restructured its debt in 2012. EBA data show that, between September 2011 and last December, Deutsche cut its exposure to Spain and France, though it increased its Italian exposure slightly. BNP Paribas cut its Spanish and Italian positions but upped its exposure to France.
"Some banks, especially those with large international operations, weigh risks that smaller domestic-oriented banks don't - reputational and debt sustainability risks," said Panigirtzoglou.
National regulators, which are typically close to their own governments, have until now had jurisdiction over eurozone banks and their sovereign exposures. That all changes next month, when the ECB takes responsibility for larger and mid-sized institutions. But analysts doubt the central bank will force a revision of the rules.
"When the ECB will become Europe's bank regulator, there may be a conflict of interest between that function and their monetary policy mandate," said Gallo at RBS. "On the one hand the central bank wants yields to be low, and banks to buy government paper. On the other, they need banks to be strong – and not only survive on carry trades. The solution may be to reform the weak banks upfront."
But with debt-to-GDP ratios rising to what some consider unsustainable levels, the possibility looms of more sovereign restructurings over the medium term – and deep losses for banks with large exposures. Debt-to-GDP ratios stood at 92% in Spain and France and 128% in Italy at the end of last year, according to Eurostat. Greece's ratio was 129% in the last full year before asking for a bailout.
"Italy and France both have unsustainable government finances, and there will have to be a debt restructuring across the periphery – including France at some stage in the future," said Megan Greene, chief economist at Manulife Asset Management. "These government bond holdings may look fine to regulators now. But they could very quickly become a big problem."
(Reporting by Gareth Gore; Editing by Marc Carnegie and Matthew Davies)