Europe Is in Danger of Another Sovereign Debt Doom Loop
(Bloomberg Opinion) - The European Union has relaxed its banking framework - which has been carefully built over the past ten years since the financial crisis - to deal with the effects of the corona virus. Unfortunately, the move could cause major problems if economic activity does not recover.
This is because regulations are being relaxed, just as the European Central Bank is about to add an enormous amount of liquidity to the euro area monetary system. This will almost certainly result in commercial lenders buying more government bonds through so-called carry trades - where they borrow cheaply from the ECB and try to make a safe profit by buying investment grade bonds that bring more than their borrowing costs.
So banks will take on more debt from their national governments and possibly create a hell of a doom loop that a bank will struggle with when the value of their government bonds goes into a market crisis (say, when the economy picks up again) - and the fate of the lender and the sovereign would be connected. This became a systemic threat at the beginning of the last decade, which triggered the 2012 euro crisis.
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Europe's financial response to the pandemic has been admirable, and it makes sense to relax the banking rules to ensure that the economy can turn again. But the latest relaxation is risky. It will temporarily prevent lenders from impacting their capital ratios if their government debt portfolios lose value, essentially eliminating some of the market valuation requirements (ie, depreciating market losses).
This is a bold move as the ECB is pumping up the banking sector with as much liquidity as it wants to spend as it wants. According to analysts from Jefferies International Ltd. EU banks' holdings of euro government bonds have already jumped a record 200 billion euros ($ 225 billion) in the past three months. Looser capital regulations will only increase the attractiveness.
The main event this week will be a new round of ultra-cheap ECB bank lending, known as targeted long-term refinancing operations (TLTROs), with interest rates as generous as minus 100 basis points. The central bank is literally paying loans to banks. Frederik Ducrozet, strategist at Pictet Wealth Management, estimates that the lenders will raise € 1.2 trillion. Inevitably, some are parked in liquid government debt, at least for a short time.
Much of this additional money is used by bankers in these carry trades. In this case, banks will borrow -1% in the TLTRO system and then invest in government-grade and investment-grade corporate bonds that deliver a hefty return. This could improve banks' poor profitability, but at what cost if it means lenders are holding too much government debt?
It is one thing for the ECB to own up to 450 billion euros in Italian government bonds, and another for commercial lenders to be exposed to such a nation. Italy's Intesa Sanpaolo SpA is already the second largest creditor in the country with around € 100 billion in government debt. It may not be a good idea to invest even more government bonds in the Italian banking system, which holds a higher percentage of its country's bonds than any other country in the euro area.
The impetus to put more money into the financial system and promote government borrowing is completely understandable at the moment. However, there is a risk that the euro zone will once again be exposed to the Achilles heel of a banking system that finances public debt. All of this may be necessary to revitalize the European economy, but the danger lurks.
This column does not necessarily reflect the opinion of the editors or Bloomberg LP and its owners.
Marcus Ashworth is a columnist in the Bloomberg Opinion, which covers the European markets. He has worked in the banking industry for three decades, most recently as Chief Markets Strategist at Haitong Securities in London.
Elisa Martinuzzi is a Bloomberg Opinion columnist who deals with finance. She is a former editor-in-chief for European finance at Bloomberg News.
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