The five stages of grief provide a roadmap to better understand the emotional basis of the European crisis: denial, anger, bargaining, depression and finally acceptance. Accepting sovereign debt restructuring shows policymakers are moving beyond denial towards eventual acceptance. However, acceptance means restructuring that achieves a sustainable debt load. Because the process of coming to this conclusion will keep financial market uncertainty high, our recommendation on European bank debt and shares represents a one-to-two quarter outlook rather than a multi-year one. This means use mutual funds and ETFs as opposed to individual bonds to take advantage of our positive sentiment to start 2012.
To better understand the European crisis, consider its emotional basis: Europe grieves over the loss of its "cradle to grave" welfare state. The five stages of grief provide a roadmap to where we have been and to what lies ahead: denial, anger, bargaining, depression and finally acceptance. For most of the crisis, policymakers in Europe have been stuck in that first stage of denial. But accepting sovereign debt restructuring shows policymakers are moving beyond denial towards eventual acceptance. Europe will still need to pass through the stages of anger, bargaining, and depression however before reaching that end. And that means that ultimately the people must decide, requiring a plebiscite, and leaving much political uncertainty for financial markets to yet digest.
The long run success of the European Union requires individual countries to give up sovereignty. In place of individual sovereignty, Europe will need to enforce sustainable fiscal policies through greater fiscal union. But this outcome remains years — even decades away. In the near term, the debt restructuring of Greece represents the first challenge for financial markets in 2012. Eventually, this restructuring must result in a sustainable debt load. But the process of coming to this conclusion will keep financial market uncertainty high. We expect continued volatility from European political headwinds, and our recommendation on European bank debt and shares represents a one-to-two quarter outlook rather than a multi-year one. That means use mutual funds and ETFs to express our positive sentiment to start 2012.
A financial game of chicken
The political process operates at much too slow a pace for financial markets to bear. In the interim, only the ECB, through the slow and steady expansion of its balance sheet, can support this process and the long time frame it requires. The ECB must strike a careful balance. On the one hand, providing too much support in the bond markets could undermine market pressure forcing politicians to act. But on the other, providing too little support to financial markets could see them collapse.
The Historical Roots of European Central Bank Aversion to Quantitative Easing
"The country was in perpetual turmoil, constantly on the brink...run by a series of weak coalition governments, and was quite unable to control its finances...the governments took on enormous new social obligations: an eight-hour day for workers, insurance for the unemployed, health and welfare payments." - The Lords of Finance, Liaquat Ahamed, 2009.
Sound like Greece or Italy or Portugal? The passage continues... "Germany's financial problems were mostly selfinflicted. Reparations payments made what was already a difficult fiscal situation impossible. To finance the gap, the various governments of Germany resorted to the Reichsbank to print the money."
And what followed was the greatest experience in hyperinflation in European history.
But the ECB must also balance its own historic aversion towards moving too far into the realm of fiscal policy and its political hazards. Such feelings are deeply rooted in the institution as the brief historical example in the above sidebar helps to clarify.
As a result, rather than finance sovereigns directly, the ECB expands its support of bank funding. With that funding in place, the banking system, can help play the critical role of supporting sovereign funding during 2012 with the substantial financing needs of Spain, Italy and France (Figure 1).
Unlike the peripheral countries of Greece, Ireland and Portugal, these core European countries have a much higher share of their funding provided by domestic banks and residents: around 50% for Spain and France and 60% for Italy. The ECB's actions help sovereigns meet their funding needs by helping banks at a minimum simply maintain their holdings. The actions may also help banks expand their holdings, but that depends in large part on the perceived risk associated in doing so. A large part of the declines in prices of sovereign debt of Spain and Italy in 2011 followed the efforts of banks to decrease their sovereign debt holdings (Figure 2). Banks reduced their sovereign debt holdings as a consequence of fears of sovereign losses as well as the difficulties they face in funding their balance sheets.
Notably the banks' fears of sovereign losses, has been greatly lessened by the statement of euroarea heads of state on December 9, 2011 regarding involvement of the private sector. By affirming that the actions taken in Greece on July 21, 2011 were "unique and exceptional", the heads of state indicated that any future private sector involvement (meaning bank losses on their sovereign holdings) would follow IMF " principles and practices." This clarification means that banks would only take losses on other sovereign debt holdings in the context of an IMF administered program, a process that increases the threshold for realizing a sovereign debt restructuring. In doing so, they lowered the risk of losses on banks' existing sovereign debt, particularly their holdings of peripheral country debt. As these holdings mature, they are rolled off of bank balance sheets and onto the IMF and ECB balance sheets. Effectively, over time the share of peripheral debt will be held in greater proportion by the public sector. As a result, the burden of any eventual debt restructuring will be borne to a large degree by the public sector. This outcome frees up capacity of the private sector to maintain (and possibly even expand) its sovereign debt holdings of the core countries of Spain, France and Italy.
Figure 1: Estimated Financing Needs in 2012:
Spain, Italy and France
Source: Bank of America/Merrill Lynch. As of December 9, 2011
*Based off Debt/GDP 2012 ratio for Spain -5.9%, France -5.3% & Italy -2.3%.
Figure 2: Percent Reduction in Sovereign Debt Holdings
Source: European Banking Authority, Company Reports.
Further support for sovereign funding can also come from the ECB's Securities Market Program (SMP). Here, the ECB purchases sovereign debt in the secondary market, with such purchases to date totaling €200bn (Figure 3). Continuing on the 2011 average weekly pace of €8-€10bn per week in 2012 implies nearly €500bn of sovereign debt issuance support. This more than accounts for the estimated net new issuance from Spain, Italy and France in 2012, and contributes to financing their gross refinancing needs.
Figure 3: Total Securities Market Purchase Program Purchases to Date
Source: European Central Bank
Figure 4: Total Funding Provided by ECB to Greece, Ireland and Portugal
Source: European Central Bank
A Brief Explanation of European Funding Markets
Interbank Market: The market in which banks borrow and lend to each other, generally over short maturities.
Basis Swap: A basis swap is an agreement whereby two counterparties agree to swap payments denominated in different currencies. For example, a euro/dollar basis swap allows a European bank to obtain dollar funding (and make payments in dollars) in return for providing euro denominated funding (receiving payments in euros).
LIBOR: London InterBank Offering Rate. "LIBOR" and "LIBOR fixings" refers to a benchmark measure of banks' funding costs produced daily through a survey conducted by the British Banking Association.
Fed $ Swap Lines: The US Federal Reserve maintains agreements with global central banks to provide dollar funding to local banking systems through their central bank. The Fed exchanges dollars for euros with the ECB and the ECB turns and lends those dollars to local European banks against euro denominated assets. Those assets form the collateral against the credit and currency risks the ECB takes in making this dollar loan to the European bank. The Fed takes no direct credit risk and faces the risk of repayment of its dollars only from the ECB.
Repo: Short for repurchase agreement. Effectively this is a collateralized loan where, for example, the ECB provides funding (euros) to a European bank against the delivery of eligible collateral (a government bond, corporate bond or virtually any other asset on the bank's balance sheet).
It's not the rate, it's the collateral
When confidence in the banking system declines, funding from normal sources such as depositors or lenders becomes difficult. These sources increase the cost of lending to the bank (by requiring higher deposit rates or term interest rates) and decrease the amounts they are willing to lend as well as shorten the time over which they are willing to hold deposits (e.g. moving from holding a 1 year deposit to only being willing to hold a 1 month deposit). For these banks suffering funding difficulties, the ECB lends not freely, but against collateral. Hence the limit on the ECB's ability to ease the funding strains plaguing European banks is not the interest rate but the availability of collateral eligible for funding at the ECB.
The ECB's expansion of eligible collateral for funding on December 8, 2011 represents a critical inflection point in the ongoing crisis. Effectively, nearly every asset on a European bank's balance sheet is now eligible as collateral for funding (see "A brief explanation..." above for more details). This action greatly limits the risks to the European an global financial markets from a collapse in European bank funding. It provides up to three years of funding (through the 36-month long-term repo facilities) providing time for European banks to work through their balance sheet restructuring. This has greatly contributed to easing the immediate concerns of rapid bank deleveraging easing both bank and economic concerns.
It's a Wonderful Life: Anatomy of a Banking Crisis
On the way to his honeymoon, Jimmy Stewart's character, George Bailey, spots commotion brewing outside his bank — the Bailey Building and Loan. When he enters the bank he explains the principles of banking to his panicked depositors:
"No, but you...you...you're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house -- right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why you're lending them the money to build, and then, they're going to pay it back to you as best they can. Now what are you going to do? Foreclose on them?"
The European crisis — much as the US financial crisis of 2008 — reached its climax in a modern version of this scene, a run on the bank. Following the Lehman Brothers default, the Primary Reserve Fund broke its $1.00 NAV level and a 21st century run on the bank ensued: a run on the money market funds. The rest was US credit crisis history.
In Europe, a run of similar proportion lurks around the corner of the sovereign crisis. The anatomy of a banking crisis is remarkably similar across time and place: concerns over the quality of a bank's assets prompts a reconsideration of lenders' confidence. A loss of confidence results in the banks loss of funding resulting in the bank's failure.
Modern central banking arose out of a need to stem these recurrent panics of 19th century banking. A "lender of last resort," the central bank could provide the bank with temporary funding to allow the time the bank needed to unwind its affairs, stepping in immediately to pay the outgoing depositors their money back. But such "lender of last resort" role entails great risk for the central bank. Walter Bagehot's 19th century advice (from Lombard Street) remains as applicable today as it was over a hundred years ago: lend against good collateral, and at a high rate of interest. Good collateral ensures the central bank from taking losses, and a high rate of interest discourages unnecessary usage.
Arguably, the ECB breaks both of the rules of central banking during a crisis: (i) lend against good collateral and (ii) at a penalty rate of interest. Instead, the ECB is providing low rates of interest against assets of increasingly lower credit quality, illustrating the increasingly desperate nature of the crisis. Sovereign risk in Europe spread to the financial sector as lenders questioned the quality of the formerly "risk free" sovereign debt assets on bank balance sheets. Funding sources successively disappeared for European banks from deposits, to commercial paper, to interbank loans and longer-dated bond funding. As a result, banks in the weaker countries have had to turn increasingly to the ECB to fund their balance sheets (Figure 4). And while the stress in the peripheral countries has been going on for some time, the story of 2011 was the shift of the European crisis into the "core" countries of Spain, Italy and France (Figure 5). The banking systems of these countries have also increasingly needed to rely on ECB funding for their operations following the announcement of the Greek debt restructuring in July 2011.
Measuring bank funding risk
Strains in bank funding can be measured through various means (see "A brief explanation..." above for an explanation of European funding markets). These measures form key indications of European bank funding risk that broader financial market participants monitor to gauge the degree of stress in the banking system. For example, the general lack of availability of collateral on weaker European banks' balance sheets to post against dollar funding at the ECB through its swap lines with the Fed explains the sharp rise in the cost of obtaining dollar funding in the euro/dollar basis swap market, a market for dollar funding used by European banks. The increase in funding costs in this market in turn bleeds over into the more widely followed LIBOR funding market indicators which represent generic funding levels for a group of banks.
Figure 5: Core Country Increased Reliance on ECB Funding
Source: National Central Banks, European Central Bank.
Ever since these measures foreshadowed the collapse of stocks in the 2008 crisis, virtually every institutional investor actively monitors them. This has led to herd behavior regarding risk appetite related to these measures of strain in the bank funding markets.2
The significance of the ECB's expansion of eligible collateral then is to greatly reduce the funding pressures on European banks and for a significant (read 3 years) period of time. The first of these new measures came into force on December 21, 2011. Look for the broader measures of banking funding strains, such as LIBOR, to decline albeit with a lag. And as the funding pressures decline, so too should market risk aversion arising out of fear that this rolling "run on the bank" will lead to an immediate bank failure. In such an environment, risk assets' performance can improve, along with broader measures of risk appetite which all else equal is rarely the case, absent further escalation of systemic risk from other sources, risk assets should do well to start the year with those closest to the crisis — European bank shares and debt — in the lead.
Figure 6: Measures of Bank Funding Costs
3M Euro/Dollar Basis Swap, 3M LIBOR-OIS Spread
Figure 7: Funding Strains Relate to Macro Market Uncertainty
2 For example, the Bloomberg professional terminal, a pricing and analytics platform most commonly used by institutional investors added a dedicated feature to its system to track these measures following the crisis.
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