Eurozone Recession Could Cause Big Banks to Fail and Trigger “Bail-Ins”

by the Curmudgeon

Overview of Eurozone's Sputtering Recovery:

Most knowledgeable people are aware that the U.S. has experienced the weakest economic “recovery” in the post WWII era. Last Saturday's Wall Street Journal lead story (on line subscription required) said the pace of the U.S. economic expansion has been by far the weakest of any since 1949. But few Americans know that the Eurozone’s “recovery” has been equally weak!

On August 1^st, the Associate Press reported (via the San Francisco Chronicle) that the Eurozone, which is made up of 19 countries that use the Euro single currency, suffered a sizable slowdown in the second quarter despite a number of extraordinary stimulus measures that the European Central Bank (ECB) has engaged in. Eurostat, the EU’s statistics agency, said that 2^nd quarter growth across the Euro currency bloc eased to a quarterly rate of 0.3% from the previous quarter’s 0.6 percent. The Eurozone’s growth was equivalent to the 1.2% annualized rate also reported Friday for the United States.

Most forecasters think Brexit will weigh to some degree on growth over the coming months, especially if the discussions around the exit drag on. Few think annual growth will be much more than a modest 1.5 % this year and next. As a result, many economists think the ECB will back a further stimulus package at its next policy meeting on September 8^th.

“The weakening in economic growth, together with the downward revisions in expectations for the outlook are setting the scene for more stimulus measures,” said Danae Kyriakopoulou, managing economist at the Center for Economics and Business Research in London. Ms. Kyriakopoulou says that the ECB will probably expand its bond-buying stimulus program rather than further cut its interest rates, which has the potential to undermine banks profitability.

The Curmudgeon has repeatedly claimed that such QE/debt monetization/ bond buying has been counter-productive to economic growth while pumping up and hyper inflating financial assets to unbelievable levels.

Message to ECB Prez Mario Draghi: Continuing to do what doesn't work is the definition of insanity!

European Banks Under Stress?

Let's suppose that current and future ECB stimulus fails and the Eurozone collectively sinks into recession (some European countries have been in a recession for years). How would European banks hold up, especially in light of their continued non performing/bad loans with no interest rate cushion to boost profits?

Last Saturday's NY Times analyzed that situation in an article titled: “Stress Tests Find Some Big European Banks Wanting.” The article starts by stating that “European regulators announced that new stress tests found that a handful of the region’s biggest banks would struggle in a severe economic downturn or in the next financial crisis.” The latest European stress tests examined the balance sheets of 51 European banks, representing about 70% of the region’s banking industry.

Banca Monte dei Paschi di Siena, Italy’s oldest and third largest bank, was the worst performer in this year’s stress tests. Its capital fell to negative in a crisis situation modeled by the European Banking Authority, which regulates lenders in the European Union. Allied Irish Bank and the Royal Bank of Scotland were among the other banks with so-called Tier 1 capital ratios that declined sharply in the tests. And among the region’s larger banks, the Tier 1 capital ratios of the Italian big bank UniCredit, Barclays of Britain and Deutsche Bank of Germany would all fall below 8% in the hypothetical economic crisis that was modeled by the European Banking Authority. Please refer to the table below, courtesy of the Wall Street Journal.

Under this year’s simulations, bank balance sheets were tested against the impact of a macroeconomic downturn over three years, in which real gross domestic product would decline by 1.2% in the European Union in 2016, fall by a further 1.3% in 2017 and recover slightly in 2018.

The biggest impact came from credit losses; banks across the region suffered cumulative losses of €349 billion. The results also forecast market risk losses of €148 billion and a cumulative loss of €105 billion from so-called conduct risk.

The European Banking Authority examination also found that the average return on regulatory capital for banks in the test sample was 6.5% at the end of 2015, which is below the cost of equity and return on equity that banks consider sustainable long term, the regulator said.

“This data shows that profitability remains an important source of concern and a challenge for the EU banking system, in a context of continued low interest rates, high level of impairments linked to large volumes of nonperforming loans, especially in some jurisdictions, and provisions arising from conduct and other operational risk related losses,” the European Banking Authority said in its report.

Italy's Troubled Banks:

As Victor pointed out in item 8. of a recent Curmudgeon post, concern is mounting about the ability of Italy’s banks to deal with hundreds of billions of euros in problem loans. As noted above Banca Monte dei Paschi is among the most troubled of Italy's banks with UniCredit not far behind. It's important to note that smaller Italian “banks on the brink” were not covered by Friday's stress tests, even though they're struggling with 360 billion euros ($400 billion) in loans gone bad.

The size of nonperforming loans on the books of Italian banks come to €360 billion (Source: NY Times article referenced above). According to the Bank of Italy, about €210 billion of those loans are held by insolvent borrowers, and an additional €150 billion are loans that are considered unlikely to be repaid, past due or in breach of an overdraft ceiling. Some of those loans could ultimately be repaid.

Fixing the banks is crucial for Italy and the wider Eurozone, because financially weak banks are more reluctant to lend out money to households and businesses, stifling the potential for economic growth needed to create jobs. Also, saving banks has in the past overwhelmed some Eurozone states' public finances, such as Ireland in 2010. With Italy ranking as the third-largest Eurozone economy, any crisis of confidence over the state's financial health has the potential to rekindle concerns about the overall currency's integrity.

European Bail-Ins:

New European rules, adopted after the 2008-2009 financial crisis, require bondholders to take much of the losses before a government-backed bailout can be put in place. Such a process is known as a “bail-in,” which we've covered in several Curmudgeon posts last year.

The key new rule is that no bank can be bailed out with public money until creditors accounting for at least 8% of the lender’s liabilities have stumped up. So-called bail-ins typically mean wiping out creditors’ investments, slashing their value or converting them into shares in the bank. Uninsured depositors could get caught along with professional investors.

The threat of “bail-ins” could have a major impact on the confidence of investors in Italy, as many small investors there hold bank bonds.

Hugo Dixon of Reuters wrote a superb analysis of “bail-ins” earlier this year. Here's an excerpt:

The theory is that shareholders should take the first hit because they know they are risking their money. If that isn’t enough to stabilize the bank, subordinated bondholders should step up because they too should know such investments are risky. Next in line are senior bondholders and, finally, uninsured depositors – which, in the EU, means those with more than 100,000 euros in their accounts. The small depositors should not be touched.

Unfortunately, bail-ins are harder in practice than in theory. A big test came during the Cypriot crisis of early 2013. The euro zone’s initial instinct was to tax all depositors, big and small, to fill the gap in bank balance sheets. Although that bad idea was abandoned, large depositors suffered singeing losses, helping cause a steep recession.

Other countries do not want to repeat the Cypriot experiment. No wonder Italy and Portugal rushed to rescue some of their troubled banks before the tough new regime kicked in at the start of January.

Not that Rome and Lisbon had a free hand over what to do. Since mid-2013, the commission has said public money could only be used to bail out lenders if shareholders and subordinated bondholders shared the burden. Still, this was not as tough as the new 8% rule, which could require senior bondholders and uninsured depositors to take a hit too.

Italy's PM: Bail-Ins NOT WANTED Here!

On August 2^nd (today), Italian Prime Minister Matteo Renzi said he wanted to avoid a "bail-in" -- the use of creditor or depositor money to restructure banks. That was just two business days after Banca Monte dei Paschi secured a last-minute, privately-funded bailout, which includes the sale of 9.2 billion euros ($10.3 billion) in bad loans and a 5 billion-euro capital increase.

"For me Italy is totally fighting for avoid bail-in because also soft bail-in could be a disaster for the credibility and for the confidence," Renzi said in an interview with CNBC.

Renzi came under heavy criticism last year when a similar burden-sharing plan was used to restructure four small banks, because some of its subordinated bondholders whose money was bailed in were ordinary savers who did not know their risk. One committed suicide.

Having to use the EU's new bail-in rules now would open the Italian PM up to political risks he probably does not want to take ahead of a referendum on constitutional reform later this year that may be crucial to the survival of his government.

"I will win," Renzi said of the referendum in the same interview. "But I think people need to understand what instability will follow."

Summary & Conclusions:

1. The key take-aways from this post are that: the Eurozone economy is very weak, monetary stimulus is not only ineffective but counter-productive for economic growth, a few European banks won't be able to survive a pro-longed recession, and bail-ins would result with many bank bondholders and depositors taking a “haircut.”

2. The entire financial world is in an Alice in Wonderland mode of operation, or even worse- a Kafka dream.¹The explosion in global debt (especially since 2009) undermines economic growth and the world has never been more indebted. Led by Japan, debt levels of many countries have reached levels far higher than 90% of GDP.

While there's been a nonstop race to the bottom by the world's central bankers (the Fed, ECB, BoJ, BoE, etc.) without any meaningful or effective fiscal policies, the global economy remains incredibly weak -- more than seven years into a so called “economic recovery.” Equally important, many big banks would not be able to survive a severe recession. Their failure would trigger bail-ins that no one likes.

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Note 1. In Franz Kafka's short story “A Dream,” the narrator describes a dream in which Joseph K. is walking through a cemetery. There are tombstones around him, and the setting is typically misty and dim.

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3. Trying more of the same with bond buying (all big central banks), perpetual debt and ETF buying (BoJ), negative interest rates (ECB, BoJ, etc.) actually wrecks a nation/regions financial system and puts big banks under much more pressure then they are now with ultra-low (or negative) interest rates.

We wonder if our great global central banker “friends” have seen the movie Dumb and Dumber?

End Quote:

In his opening narrative for each TV episode, Rod Serling would say: “Next stop, the Twilight Zone.” Let's update that to what today's central bankers might say in their opening remarks: “Next stop, Helicopter Money²!”

Note 2. Podcast: QE and Helicopter Money Questions Answered

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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