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TWN
Info Service on Finance and Development (Mar12/07)
19 March 2012
Third World Network
Fears ease over European bank funding and de-leveraging
Published in SUNS #7328 dated 13 March 2012
Geneva,
12 Mar (Kanaga Raja) - An easing of fears that funding strains and other
pressures on European banks to de-leverage could lead to forced asset
sales, contractions in credit and weaker economic activity resulted
in asset prices recovering some of their previous losses between early
December and the end of February, rising equity prices and gains in
credit markets.
This is one of the main findings of the Basel-based Bank for International
Settlements (BIS) in its latest quarterly review released on Monday.
In its review, BIS concludes that pressures on European banks to de-leverage
increased towards the end of 2011 as funding strains intensified and
regulators imposed new capitalisation targets. Many of these banks shed
assets, both through sales and by cutting lending.
"However, this did not appear to weigh heavily on asset prices,
nor did overall financing fall for most types of credit. This was because
other banks, asset managers and bond market investors took over the
business of European banks."
According to BIS, an open question is whether other financial institutions
will be able to substitute for European banks as the latter continue
to de-leverage.
"The reduction in de-leveraging pressures in late 2011 and early
2012, after measures by central banks mitigated bank funding strains,
means at least that this process may run more gradually. This should
reduce any impact on financial markets and economic activity."
According to the quarterly review of March 2012, asset prices broadly
recovered some of their previous losses between early December and the
end of February, as the severity of the euro area sovereign and banking
crises eased somewhat. Equity prices rose by almost 10% on average in
developed countries and by a little more in emerging markets. Bank equity
prices increased particularly sharply. Gains in credit markets reflected
the same pattern.
"Central to these developments was an easing of fears that funding
strains and other pressures on European banks to de-leverage could lead
to forced asset sales, contractions in credit and weaker economic activity."
The review finds that funding conditions at European banks improved
following special policy measures introduced by central banks around
the beginning of December. Before that, many banks had been unable to
raise unsecured funds in bond markets and the cost of short-term funding
had risen to levels only previously exceeded during the 2008 banking
crisis. Dollar funding had become especially expensive.
The ECB (European Central Bank) then announced that it would lend euros
to banks for three years against a wider set of collateral. Furthermore,
the cost of swapping euros into dollars fell around the same time, as
central banks reduced the price of their international swap lines. Short-term
borrowing costs then declined and unsecured bond issuance revived.
At their peak, says BIS, bank funding strains exacerbated fears of forced
asset sales, credit cuts and weaker economic activity. New regulatory
requirements for major European banks to raise their capital ratios
by mid-2012 added to these fears.
European banks did sell certain assets and cut some types of lending,
notably those denominated in dollars and those attracting higher risk
weights, in late 2011 and early 2012.
However, there was little evidence that actual or prospective sales
lowered asset prices, and overall financing volumes held up for most
types of credit. This was largely because other banks, asset managers
and bond market investors took over the business of European banks,
thus reducing the impact on economic activity.
According to the review, European bank funding conditions deteriorated
towards the end of 2011, as faltering prospects for economic growth
and fiscal sustainability undermined the value of sovereign and other
assets. Bond issuance by euro area banks in the second half of the year,
for example, was just a fraction of its first half value.
Until December, un-collateralised issuance by banks in countries facing
significant fiscal challenges was especially weak. Deposits also flowed
out of banks in these countries, with withdrawals from Italy and Spain
accelerating in the final quarter of the year.
At this time, says BIS, US money market funds significantly reduced
their claims on French banks, having already eliminated their exposures
to Greek, Irish, Italian, Portuguese and Spanish institutions.
The pricing of long- and short-term euro-denominated bank funding instruments
also deteriorated, both in absolute terms and relative to that of non-euro
instruments, as did the cost of swapping euros into dollars.
Around early December, BIS notes, central banks announced further measures
to help tackle these funding strains. On 8 December, the ECB said that
it would supply banks in the euro area with as much three-year euro-denominated
funding as they bid for in two special longer-term refinancing operations
(LTROs) on 21 December 2011 and 29 February 2012.
At the same time, it announced that Euro-system central banks would
accept a wider range of collateral assets than previously.
The ECB also said that it would halve its reserve ratio from 18 January,
reducing the amount that banks must hold in the Euro-system by around
100 billion euros. A few days earlier, six major central banks, including
the ECB, the Bank of England and the Swiss National Bank, had announced
a 50 basis point cut to the cost of dollar funds offered to banks outside
the United States. They also extended the availability of this funding
by six months to February 2013.
Euro area banks raised large amounts of funding via the ECB's three-year
LTROs, covering much of their potential funding needs from maturing
bonds over the next few years. Across both operations, they bid for
slightly more than 1 trillion euros. This was equivalent to around 80%
of their 2012-14 debt redemption, more than covering their un-collateralised
redemptions.
Banks in Italy and Spain made bids for a large proportion of the funds
allocated at the first three-year LTRO, while the funding situation
of banks in other regions improved indirectly. Banks in Germany, Luxembourg
and Finland, for example, did not take much additional funding at the
first LTRO.
However, some of the allotted funds, perhaps after a number of transactions,
ended up as deposits with these banks, boosting the liquidity of their
balance sheets. In turn, they significantly increased their Euro-system
deposits.
According to BIS, there was also little change in the LTRO balance at
the Greek, Irish and Portuguese central banks. However, banks in these
jurisdictions had already borrowed a combined 165 billion euros before
December and may have been short of collateral to use at the first LTRO.
Bank funding conditions improved following these central bank measures.
Investors returned to long-term bank debt markets, buying more un-collateralised
bonds in January and February 2012 than in the previous five months.
US money market funds also increased their exposure to some euro area
banks in January. Indicators of the cost of long- and short-term euro-denominated
bank funding instruments also turned, as did the foreign exchange swap
spread for converting euros into dollars.
The review finds that funding conditions for euro area sovereigns improved
in parallel to those of banks in December 2011 and early 2012. Secondary
market yields on Irish, Italian and Spanish government bonds, for example,
declined steadily during this period. Yields on bonds with maturities
of up to three years fell by more than those of longer-dated bonds.
At this time, these governments also paid lower yields at a series of
auctions, despite heavy volumes of issuance.
"One notable exception to this trend was the continued rise in
yields on Greek government bonds. This reflected country-specific factors,
including the revised terms of a private sector debt exchange and tough
new conditions for continued official sector lending."
BIS explains that part of the decline in government bond yields appeared
to reflect diminished perceptions of sovereign credit risk. This was
consistent with declines in sovereign CDS (credit default swap) premia.
In turn, part of the reduction in sovereign credit risk probably reflected
improvements in bank funding conditions.
A further part of the decline in yields on government bonds appeared
to reflect the additional cash in the financial system available to
finance transactions in these and other securities. This was consistent
with government bond yields declining by more than CDS premia.
Banks in Italy and Spain, for example, used new funds to significantly
boost their holdings of government bonds. While other euro area banks
were less active in this respect, they may have committed new funds
to help finance positions in government bonds for other investors. Or
they may have purchased other assets and the sellers of those assets
may have invested the resulting funds in government bonds.
"These improvements in funding terms for euro area sovereigns fed
back into bank funding conditions. In particular, higher market values
of sovereign bonds enhanced the perceived solvency of banks, which made
them more attractive in funding markets. However, this link earlier
worked in reverse and could potentially do so again."
According to BIS, the sharp rise in funding costs and growing concerns
over adequate capitalisation toward the end of 2011 added to existing
market pressures on European banks to de-leverage. De-leveraging is
part of a necessary post-crisis adjustment to remove excess capacity
and restructure balance sheets, thus restoring the conditions for a
sound banking sector.
That said, the confluence of funding strains and sovereign risk led
to fears of a precipitous de-leveraging process that could hurt financial
markets and the wider economy via asset sales and contractions in credit.
The extension of central bank liquidity and the European Banking Authority's
(EBA) recommendation on bank recapitalisation, however, played important
parts in paving the way toward a more gradual de-leveraging process.
The European bank recapitalisation plan announced in October 2011 brought
fears of de-leveraging to the forefront of financial market concerns.
The plan required 65 major banks to attain a 9% ratio of core Tier 1
capital to risk-weighted assets (RWA) by the end of June 2012, and the
authorities identified a combined capital shortfall of 84.7 billion
euros at 31 major banks as of end-September 2011.
Banks can de-leverage either by re-capitalising or by reducing RWA,
with different economic consequences. In order to safeguard the flow
of credit to the EU economy, supervisory authorities explicitly discouraged
banks from shedding assets.
The review notes that banks thus planned to meet their shortfalls predominantly
through capital measures, and some made progress in spite of unfavourable
market conditions. Overall, banks plan to rely substantially on additions
to capital and retained earnings to reach the 9% target ratio. The actions
and plans of EBA banks thus helped to ease market fears over potential
shedding of assets among banks with capital shortfalls.
In view of recurring funding pressures and changing business models,
many banks, with or without EBA capital shortfalls plan to extend the
ongoing trend of shedding assets. Industry estimates of overall asset
disposals by European banks over the coming years thus range from 0.5
trillion euros to as much as 3 trillion euros.
According to BIS, the extension of central bank liquidity eased the
pace of asset-shedding observed in late 2011, but did not turn the underlying
trend. If the banks in the EBA sample, for instance, failed to roll
over their senior unsecured debt maturing over a two-year horizon, which
amounts to more than 1,100 billion euros (600 billion euros among banks
with a capital shortfall), they would have to shed funded assets in
equal measure.
By covering these funding needs, the LTROs and dollar swap lines helped
avert an accelerated de-leveraging process. But many banks continued
to divest assets in anticipation of the eventual expiration of these
facilities.
The review finds that as de-leveraging pressures grew towards the end
of 2011, European banks offered for sale a significant volume of assets,
notably those with high risk weights or market prices close to holding
values. Offerings with high risk weights included low-rated securitised
assets, distressed bonds and commercial property and other risky loans.
Although some such transactions were completed, others did not go through
because the offered prices were below banks' holding values. Selling
at these prices would have generated losses, thus reducing capital and
preventing the banks from achieving the intended de-leveraging.
In contrast, other offerings included aircraft and shipping leases and
other assets with steady cash flows and collateral backing, since these
often fetched face values and thus avoided losses.
Despite this, BIS underscores, there is little evidence that actual
or expected future sales significantly affected asset prices.
Strong de-leveraging pressures during the final quarter of 2011 were
also associated with weak or negative growth in the volume of credit
extended by many European banks. Credit extended by financial institutions
in the euro area, for example, turned down during this period, with
credit to non-bank private sector borrowers in the area falling by around
0.5%, while assets vis-a-vis non-euro area residents declined by almost
4%.
Outstanding loans to euro area non-financial corporations grew by just
over 1% and loans to households for house purchases by around 2%, while
consumer credit declined by just over 2%.
Lending surveys and changes in loan interest rates both suggested that
changes in supply were important drivers of weak credit volumes. For
example, many more euro area lenders tightened terms on corporate loans
than loosened them in the final quarter of 2011 and a significant balance
also tightened standards on loans to households.
In contrast, the balance between lenders reporting either increased
or reduced demand for corporate loans was much more even.
Also, says BIS, more non-US (mainly European) banks operating in the
United States tightened approval standards on loans to US corporations
than loosened them in the third and fourth quarters of 2011. This contrasted
with domestic US banks making loans to the same borrowers, who in aggregate
reported no significant tightening.
Lending cuts by European banks focused primarily on risky and dollar-denominated
loans. For example, EU banks reduced their funding contributions to
new syndicated and large bilateral leveraged and project finance loans
between the third and fourth quarters of 2011 by more than for other,
less risky types of lending.
Funds from weaker banking groups (defined as those with EBA capital
shortfalls plus all Greek banks) for project financing declined more
than proportionately.
The review also finds that European banks cut lending to emerging markets.
Their consolidated foreign claims on emerging Europe, Latin America
and Asia had already started to fall in the third quarter of 2011. New
syndicated and large bilateral loans from EU banking groups to emerging
market borrowers then fell in the final quarter of the year.
This was in contrast to lending to western Europe and other developed
countries, which was essentially unchanged.
At the same time, banks tightened terms on new loans to corporations
and households in emerging markets. The more pervasive tightening in
emerging Europe than elsewhere may have reflected the widespread ownership
of banks in the region by EU banking groups.
Reduced lending to emerging Europe may also reflect lower demand, however,
as the region's economic growth forecasts fell by more than those for
any other during the final quarter of 2011.
Increased
financing from other banks and bond market investors largely compensated
for the cuts made by European banks in the final quarter of 2011.
As a result, the overall volume of new syndicated and large bilateral
loans was essentially the same as in the third quarter. In trade finance,
for example, a strong balance of Asia-based lenders reported increased
demand and these and other non-European lenders ensured that financing
of trade did not fall overall.
More generally, types of lending mostly denominated in dollars were
quite steady in aggregate, even though contributions from European banks
declined.
Elsewhere, higher bond market issuance offset reductions in the supply
of bank credit. In particular, increased emerging market bond issuance
more than offset the corresponding decline in bank lending, while a
modest rise in high-yield bond issuance only partially offset the decline
in leveraged lending, the review concludes.
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