http://marketsandbeyond.blogspot.

com/
http://www.pcgwm.com/

Euro-zone bank's stress test: stressfull for Europe?

1. Euro zone banks in stress

Last week European Union’s decision to publish the results of stress tests on the region’s
banks was more or less imposed by the Spanish government that unexpectedly pledged to
publish results on Spanish individual banks, becoming the first European government to
do so.

I welcome more transparency and it is the only way to fend off rumors that markets are
prone to amplify. As usual, the devil will however be in the details, the quality of the test,
the amount of disclosure and the number of banks included. So far, it seems that only the
tests on the 25 largest banks will be disclosed; but what about the Cajas in Span and
Landesbanken in Gerrmany that are in trouble?

I have discussed several times challenges European countries are facing with their over-
indebtedness. This is compounded by inadequate banks' shareholders funds, in particular
with respect to their exposure to euro-zone sovereign debt and the private sector. The
banks were indeed happy to earn a bit of extra yield on supposedly risk-free assets and
loaded up their balance sheets with the weaker countries’ government debt. I doubt this
debt is marked-to-market but held to maturity instead.

The market realized this, which explains the difficulty banks have to obtain short-
term financing, the interbank and commercial paper markets have frozen again which
translated in the surge both in short-term financing and cash deposits at the ECB in the
recent past.

One may wonder who is going to buy Goverment bonds but if banks buy and immediately
re-sale to the ECB in a way to avoid no loss for banks (or pre-agreed sales at pre-agreed
prices?); in some ways banks would act as an agency broker for the ECB.

Contrarily to the US, European banks on the continent did not clean their
balance sheets in 2008 and have remained over-leveraged. They need to be
recapitalized, then the market will be convinced that there is no longer a
solvency issue.

1
 http://marketsandbeyond.blogspot.com/
http://www.pcgwm.com/

2. French and German banks exposure

The total exposure of banks in the euro zone to Portugal, Ireland, Greece and Spain
amounted to USD 1,579 billion at the end of 2009, or 2/3 of all international banks'
exposure (I bet it is higher today), Spain representing nearly half of the total. French and
German banks were the most exposed with respectively USD 493 billion and USD 465
billion, and USD 248 billion and USD 202 billion to Spain. The exposure of French
and German banks to Greek and Spanish government debt is USD 79 billion
and USD 56 billion.

2
 http://marketsandbeyond.blogspot.com/
http://www.pcgwm.com/

The combined exposures of German, French and Belgian banks to the public
sectors of Spain, Greece and Portugal amounted to 12.1%, 8.3% and 5.0% of
their Tier 1 capital. By comparison, the combined exposures of Italian, Dutch and Swiss
banks to the same public sectors were equal to 2.8%, 2.7% and 2.0%.

A collapse of the Club Med PIGS would be disastrous for the German, French
and Belgium banking sector (please note that French banks have an exposure of USD
301 billion to Belgium, by far the largest creditors).

3. Will the dark scenario materialize?

The BIS conducted a study comparing current stress on markets with the 2007-2009
financial crisis.

The current market stress has been associated with the same increase in equity volatility as
in the second half of 2007, but Libor-OIS spreads have moved up more slowly. Despite the
recent rise to around 30 basis points, three-month US dollar Libor-OIS spreads remain
well below their levels from August 2007 onwards. The current rise in the VIX initially
followed the July 2007 trajectory, but then jumped sharply, as it did in September 2008.
While cross-currency basis swaps are signalling difficulties for banks seeking to raise US
dollars, the limited participation at US dollar auctions held by the ECB, the Bank of
England and the Swiss National Bank suggests that the problem is more about
counterparty credit risk than access to foreign currency funding. In contrast to July 2007,
the euro-US dollar basis swap began the recent period at a level suggesting that stress was
already present in cross-currency funding markets. The current departure point was
similar to that of early September 2008, but the spread has widened by much less this
time in response to worsening market conditions.

There are similarities to 2007 but not enough evidence to conclude on a soon
coming crisis, based on this analysis.

3
 http://marketsandbeyond.blogspot.com/
http://www.pcgwm.com/

The continued stress on the CDS spreads is however more worrisome:

Greece, Spain, Belgium and France are reaching new highs either in absolute
terms or spread with Germany or both.

4
 http://marketsandbeyond.blogspot.com/
http://www.pcgwm.com/

From left to right and top to bottom: Italy, Greece, Spain, Portugal, Ireland, France.

This reflects deep uncertainty about refinancing problems for Spain on markets and
continued doubts about the solvency of Greece, and the impact this would have on banks
most exposed to the sovereign debt of these countries.

5
 http://marketsandbeyond.blogspot.com/
http://www.pcgwm.com/

In July, there are large euro zone sovereign financing in the turn of EUR 230
billion, including EUR 32 billion for Spain and EUR 79 billion for France (Belgium
will have EUR 21 billion in September at a time when the Government should be formed
and when Belgium takes the helm of the European Council; this may be tricky if the
situation deteriorates in Southern Europe and France, and if the new government is not
formed or if Belgium goes towards a separation between Flemish and Wallons splitting the
country in two).

My guess is that stress tests will be release just before these financings to show that
everything is fine with the banking sector, - oops, for the 25 banks reviewed, and what
about the rest (Cajas and Landesbanken in particular)? President Sarkozy of France, said
that not everything should be disclosed; if information are retained from public scrutiny,
expect a new and maybe fatal downleg for the banking sector and the euro.

The euro is political monster and will be defended tooth and nail by euro zone politicians,
like any dogma. I however believe that facts are always right in fine and therefore I expect
a new crisis to emerge in Europe within the coming months, possibly as early as July.

Source:

Bank for International Settlements: International banking and financial market

development - Quarterly review
http://www.bis.org/publ/qtrpdf/r_qt1006.pdf
Bank for International Settlements: International banking and financial market
development - Statistical annex
http://www.bis.org/publ/qtrpdf/r_qa1006.pdf