Today, the ECB announced that 523 Euro banks borrowed €489 Billion (source: Bloomberg) of 3-year loans under its emergency lending program.
There have been a number of media comments that have misunderstood the purposes and effect of this program. In sum, this is a liquidity facility which removes one risk but leaves solvency and capital issues unaffected.
All large banks finance a substantial portion of their assets through open market borrowings, as short as overnight. In ordinary times, this is a very liquid market and funds are readily available at low rates. The lenders are other banks, including US, Chinese, other Asian banks as well as US mutual funds, and other institutions that have short term funds to invest. In the last quarter, the liquidity in this market had been "drying up" as US banks (among others) began to worry obsessively about "counterparty" risk. One consequence of this can be seen in the negative yield on 1-month US Treasury bills. There is simply a strong risk aversion in the global debt markets. The cost of the overnight funds and other short term funds, the equivalent of auction CDs, for Euro banks has been increasing as availability has tightened. Last month the Fed Reserve and other central banks announced facilities to provide virtually unlimited funds to European banks. This IS important. Without this reassurance, there could have been a modern day version of a "run on the bank". As we all saw with MF Global, confidence is essential to funding large financial organizations. On this issues, let me congratulate the ECB and the Fed for making an astute move. This reassures all investors that no Euro bank is going to collapse because it could not roll-over short term debt.
The balance sheets of the European banks are somewhat opaque, so we don't know if most of these funds are simply replacing other short term, but higher cost, debt; but this is my suspicion. Because it was a requirement that all of these loans had to be collateralized, it does not seem like there will be excess funds to purchase additional sovereign debt or other assets. Nevertheless, this program should create a substantial positive carry for participating banks, which will increase profitability. This similar to the Fed's actions in 2009-10 in the US which allowed the major banks to earn their way out of the crisis. But this program eliminates counterparty risk for the major money-center banks such as JPM, C, GS and MS. The business model of the US money center banks (JPM, C, BAC) could be questionned in light of Dodd Frank and other regulatory initiatives, but the risk of European contagion from counterparties has been removed. In fact, lending money to European banks will again be a very profitable niche business.
BUT.....
The Euro banks still need additional capital for 3 primary reasons: (1) a special one time "buffer" against sovereign debt which is designed to reassure the financial markets. (2) additional capital to meet the Basel 3 requirements; and (3) additional capital to reach the 9% capital bench mark for risk weighted assets. This is going to have to be resolved in the first half of 2012. Historically, the Euro banks did not need to allocate capital to support sovereign debt because default was thought to be impossible. For purposes of calculating capital, sovereign bonds have not been marked to market. (in some cases, they are marked-to-market for accounting purposes). Today, part of the need for additional capital is to allow sovereign debt to be marked to market, ahead of the Basel 3 requirement. The remainder of the additional capital is for the purposes outlined in number 2 and 3 above.
European banks are required to present plans in January 2012. The European Banking Authority estimated the capital shortfall to be €114B. The largest shortfalls are in Greece (€30 Billion), Spain (€26Billion), Italy (€15B), and Germany (€13B). But the total amounts only tell half of the story. The other part is the size of the shortfall in relation to the size of any specific institution. In this regard, a few small-ish banks are facing large capital shortfalls when expressed as a percentage of their market capitalization. For instance, Commerzbank (PINK: CRZBY) is thought to need a capital injection of €5.8B according to the EBA, but this compares to a market capitalization of €6.8B. This is a stock to avoid due to the risk of an "AIG-like" solution or massive equity dilution. This will be doubly challenging due to that institution's history of erratic operations and profitability. On the other hand, Deutsche Bank (NYSE: DB) is thought to need capital of €3.2B according to the EBA, but this compares to a market cap of €27B. Given the size of the entity, this is likely to be raised without major dilution to shareholders.
The EBA has explicitly stated that these capital requirements are to be met by:
1. Retained earnings, including reduced bonus payments;
2. New common equity or other approved forms of capital; and
3. Sales of selected assets that do not impair lending capacity.
The EBA discouraged shrinkage of balance sheets, which would lead to contractionary pressures. Although unstated, the national governments are the investors of last resort.
A Definitive Solution is not in the cards
Most economists recognize that the "Geithner" solution would be the best way to proceed. This would require a combination of the liquidity program (which is now in place) and a massive equity capital injection similar to TARP. The mere availability of this equity capital would end the speculation about the solvency of the European banks and would free the banks to purchase government debt at something close to normal yields. However, this would require a massive sum of money; at least €2T and perhaps double that amount. Ultimately, it would be repaid, as TARP was largely repaid. Banks would raise replacement capital over a period of time, and calm, with a good share coming from retained earnings. But there is simply no political will for this program in the EU. It is seen as the strong subsidizing the profligate and accordingly is simply DOA (dead on arrival). So what is left????
Kick the can down the road, continue in small incremental steps, and hope that an economic recovery within the next decade will eventually bail out the sovereigns. In the long term, this is workable; but the path is likely to be rocky and painful at times.
There have been a number of media comments that have misunderstood the purposes and effect of this program. In sum, this is a liquidity facility which removes one risk but leaves solvency and capital issues unaffected.
All large banks finance a substantial portion of their assets through open market borrowings, as short as overnight. In ordinary times, this is a very liquid market and funds are readily available at low rates. The lenders are other banks, including US, Chinese, other Asian banks as well as US mutual funds, and other institutions that have short term funds to invest. In the last quarter, the liquidity in this market had been "drying up" as US banks (among others) began to worry obsessively about "counterparty" risk. One consequence of this can be seen in the negative yield on 1-month US Treasury bills. There is simply a strong risk aversion in the global debt markets. The cost of the overnight funds and other short term funds, the equivalent of auction CDs, for Euro banks has been increasing as availability has tightened. Last month the Fed Reserve and other central banks announced facilities to provide virtually unlimited funds to European banks. This IS important. Without this reassurance, there could have been a modern day version of a "run on the bank". As we all saw with MF Global, confidence is essential to funding large financial organizations. On this issues, let me congratulate the ECB and the Fed for making an astute move. This reassures all investors that no Euro bank is going to collapse because it could not roll-over short term debt.
The balance sheets of the European banks are somewhat opaque, so we don't know if most of these funds are simply replacing other short term, but higher cost, debt; but this is my suspicion. Because it was a requirement that all of these loans had to be collateralized, it does not seem like there will be excess funds to purchase additional sovereign debt or other assets. Nevertheless, this program should create a substantial positive carry for participating banks, which will increase profitability. This similar to the Fed's actions in 2009-10 in the US which allowed the major banks to earn their way out of the crisis. But this program eliminates counterparty risk for the major money-center banks such as JPM, C, GS and MS. The business model of the US money center banks (JPM, C, BAC) could be questionned in light of Dodd Frank and other regulatory initiatives, but the risk of European contagion from counterparties has been removed. In fact, lending money to European banks will again be a very profitable niche business.
BUT.....
The Euro banks still need additional capital for 3 primary reasons: (1) a special one time "buffer" against sovereign debt which is designed to reassure the financial markets. (2) additional capital to meet the Basel 3 requirements; and (3) additional capital to reach the 9% capital bench mark for risk weighted assets. This is going to have to be resolved in the first half of 2012. Historically, the Euro banks did not need to allocate capital to support sovereign debt because default was thought to be impossible. For purposes of calculating capital, sovereign bonds have not been marked to market. (in some cases, they are marked-to-market for accounting purposes). Today, part of the need for additional capital is to allow sovereign debt to be marked to market, ahead of the Basel 3 requirement. The remainder of the additional capital is for the purposes outlined in number 2 and 3 above.
European banks are required to present plans in January 2012. The European Banking Authority estimated the capital shortfall to be €114B. The largest shortfalls are in Greece (€30 Billion), Spain (€26Billion), Italy (€15B), and Germany (€13B). But the total amounts only tell half of the story. The other part is the size of the shortfall in relation to the size of any specific institution. In this regard, a few small-ish banks are facing large capital shortfalls when expressed as a percentage of their market capitalization. For instance, Commerzbank (PINK: CRZBY) is thought to need a capital injection of €5.8B according to the EBA, but this compares to a market capitalization of €6.8B. This is a stock to avoid due to the risk of an "AIG-like" solution or massive equity dilution. This will be doubly challenging due to that institution's history of erratic operations and profitability. On the other hand, Deutsche Bank (NYSE: DB) is thought to need capital of €3.2B according to the EBA, but this compares to a market cap of €27B. Given the size of the entity, this is likely to be raised without major dilution to shareholders.
The EBA has explicitly stated that these capital requirements are to be met by:
1. Retained earnings, including reduced bonus payments;
2. New common equity or other approved forms of capital; and
3. Sales of selected assets that do not impair lending capacity.
The EBA discouraged shrinkage of balance sheets, which would lead to contractionary pressures. Although unstated, the national governments are the investors of last resort.
A Definitive Solution is not in the cards
Most economists recognize that the "Geithner" solution would be the best way to proceed. This would require a combination of the liquidity program (which is now in place) and a massive equity capital injection similar to TARP. The mere availability of this equity capital would end the speculation about the solvency of the European banks and would free the banks to purchase government debt at something close to normal yields. However, this would require a massive sum of money; at least €2T and perhaps double that amount. Ultimately, it would be repaid, as TARP was largely repaid. Banks would raise replacement capital over a period of time, and calm, with a good share coming from retained earnings. But there is simply no political will for this program in the EU. It is seen as the strong subsidizing the profligate and accordingly is simply DOA (dead on arrival). So what is left????
Kick the can down the road, continue in small incremental steps, and hope that an economic recovery within the next decade will eventually bail out the sovereigns. In the long term, this is workable; but the path is likely to be rocky and painful at times.
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