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The European Banking System has been Fragmenting

By C.A.E. Goodhart and H. van SteenisLondon School of Economics and Morgan Stanley

 

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The initial (primarily housing) shock in 2007/8 was roughly similar in the USA and Europe, and as differentiated between worse and less affected states in the USA as in Europe. Yet in the USA the differences between the states has tended to lessen over time, with absolutely zero threat to the single currency; whereas the divergence between stronger and weaker states in Europe continues, and in some respects, e.g. unemployment, widens, to the extent that the continuation of the single currency comes under question.

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There are several reasons for the greater convergence in the USA, and divergence in Europe, a satisfactory enumeration of which would take us far beyond the scope of this presentation. But one key reason is that the US banking system has become federal in coverage, whereas in Europe (retail) banking is done primarily by banks headquartered in that State, e.g. French banks in France, Spanish banks in Spain, etc. Naturally such banks’ portfolios are focussed on national assets, both public sector (sovereign) debt and private sector (property related) debt.

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This has, of course, led to the ‘doom-loop’ between the local banks and the local State, whereby weakness in the banks forces the State into costly recapitalisation, and rising State debt burdens impinge on the funding costs of the local banks. Meanwhile, the attempts of all concerned, State, banks and private sector, simultaneously to delever becomes largely self-defeating, especially when most neighbouring States are doing the same. Also the European banks started, and remain, in a much weaker condition than their US counterparts.

Loans to Deposits

60%

70%

80%

90%

100%

110%

120%

130%

140%

150%

Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

USiTraxx S18Western Europe

TCE/TA

Western European Banking System Fundamentals vs US

Core T1 Ratio

Wholesale DependenceLoans to Deposit Ratio

Note: As of Q3 12Source: Morgan Stanley Research, SNL Financials, Bloomberg, company data

Core T1 Ratio

4%

5%

6%

7%

8%

9%

10%

11%

12%

Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

USiTraxx S18Western Europe

TCE/TA

2%

3%

4%

5%

6%

7%

8%

Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

USiTraxx S18Western Europe (GAAP-adjusted)

Wholesale Dependence

30%

35%

40%

45%

50%

55%

60%

65%

70%

75%

Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

USiTraxx S18Western Europe

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 So a current theme is increasing fragmentation (Balkanisation) despite the best efforts of the ECB, both between countries and even within countries, as weaker mid-size banks fall behind ‘national champions’. National politicians and regulators pressurise banks to focus on home country. Cross-border bank flows decline, replaced by reliance on ECB. Not enough incentive to raise new equity, so delevering will continue, maintaining downwards pressure on economies of periphery.

-1.6%

-1.4%

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

SPA GRE POR AUS ITA GER IRE NETH FRA BEL

Prev. 2Q average

Last 3m

Fragmentation persists: Divide between loan growth deepens

Source: ECB Morgan Stanley Research. Note: Data based on loans adjusted for sales and securitisations, which is largely corrected for transfers to SAREB. However, other factors linked to the orderly restructuring of the Spanish banking sector led to further reductions of loans to non-financial corporations that had a sizeable downward impact even on loan flows corrected for sales and securitisation.

Spain has seen pronounced fall in lending over the last 3 months – though in part affected by SAREB transfer

Change in flow over last 3m vs. Avg previous 2Q change in flow

Peripheral corporate lending continues to weaken

Some softening in Germany, but mild growth elsewhere in the core

Fragmentation persists: Spread between Italian/Spanish & German corporate rates widens

• Cost of new corporate loans much higher in Spain/Italy to France/Germany, as average cost of fund weigh Annualised rates on new corporate loans (overall)

Source: ECB Morgan Stanley Research. Note: Data based on loans adjusted for sales and securitisations, which is largely corrected for transfers to SAREB. However, other factors linked to the orderly restructuring of the Spanish banking sector led to further reductions of loans to non-financial corporations that had a sizeable downward impact even on loan flows corrected for sales and securitisation.

1%

2%

3%

4%

5%

6%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

SpainItalyGermanyFrance

LTRO OMT

1. What We’re Watching

German and French banking systems continue to balkanise their operations in the face of regulatory and funding pressures

Source: Morgan Stanley Research, Bundesbank.

German banks: Since peaking at ~€520bn 2009, German banks have materially shrunk their funding gap vs. GIIPS countries, with Spain bearing the brunt of contraction in recent months. €bn

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Ireland

Portugal

Greece

Italy

Spain

German and French banking systems continue to balkanise their operations in the face of regulatory and funding pressures

Source: Morgan Stanley Research, Bundesbank.

French Banks: have a ~€450bn funding gap in the Eurozone (outside France), significantly down from over €700bn at its peak €bn

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1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

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In summer 2012 a renewal of hope for the Eurozone occurred, with OMT and proposals for a Banking Union. This led to a strong rally and to some reversal of reliance by peripheral banks on ECB funding. But effectiveness of threat of OMT lessened by Italian politics, (how could they agree on conditionality?), and Banking Union now stalled, beyond and apart from making ECB into SSM. Germany, and other Northern creditor States, unwilling to move into Eurozone-wide depositor insurance and ESM.

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Moreover Cyprus provides precedent for an alternative resolution approach. Local creditor bail-in of uninsured depositors and bondholders. Will it work in Cyprus (given downturn of economy)? Will it be contagious? Data not yet available. (N.B. ECB study of relative wealth and German suggestion of property tax.) If the Cyrpus precedent is followed, then further fragmentation will ensue. EC aware and still pressing on with proposals for Banking Union, but Germany seems opposed and should be able to block. No immediate end to (banking) problems in sight, but can Draghi pull another rabbit out of his hat? 

Eurozone Liquidity Provisions

Reliance on ECB Funding – since 2008

Total Liquidity Provisions/ Total Assets

Source: Morgan Stanley Research, ECB. NCBs. Data represents latest available. * Note Cyprus data reflects total LTRO and MRO as reported on NCB balance sheet

0%

5%

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15%

20%

25%

30%

35%

Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12

Spain Portugal

Greece (incl ELA) Ireland (incl ELA)

Italy Germany

Belgium France

Austria Netherlands

Cyprus (Incl ELA) Luxembourg