For Carlo Messina, CFO and general manager of Intesa Sanpaolo Group, rarely has such a routine transaction provided such relief. In February the Italian bank completed a €1.5 billion ($2 billion) offering of 4 percent, 18-month bonds. The deal was pricey, requiring Intesa to pay an interest rate of 295 basis points over the benchmark midswap rate — more than two and a half times the spread it had paid on a previous bond issue just nine months earlier. Yet the fact that the bank could raise money at all was cause for celebration. With worries about Europe’s debt crisis sparking an investor panic late last year, no Italian bank had managed to issue senior unsecured bonds since July 2011. “Accessing the senior unsecured market was a way of diversifying our funding sources,” says Messina, “and the cost was broadly in line with that of retail funding.”
Most bankers in Europe are breathing similar sighs of relief these days. Just a few months ago, fears that Greece’s debt woes would cascade out of control sent government bond yields soaring and left banks frozen out of the markets. Institutions such as Spain’s Banco Santander and France’s BNP Paribas were scrambling to dump billions’ worth of assets. Worried that a credit crunch might hammer the economy and undermine confidence in the euro, the European Central Bank dusted off its so-called long-term refinancing operation, or LTRO, a mechanism it had introduced in 2009 to prop up the banks during the global financial crisis. Using the tool, the central bank provided €489 billion in three-year funds to a total of 523 European banks in late December. Two months later it followed up with an even bigger injection of €530 billion, also for three years, aiding a total of 800 banks.
The ECB’s intervention, backed up by a fresh European bailout and private sector debt relief for Greece, has turned Europe’s vicious circle of debt into a virtuous one. The central bank funds removed short-term concerns about bank solvency, spurring a rebound in the institutions’ share prices. With confidence restored, key funding sources reopened, enabling banks to sell tens of billions’ worth of senior debt and covered bonds. The banks, in turn, have used much of their funding to buy government bonds, causing sovereign yields to decline sharply.
“We needed to buy time, and that’s what the liquidity provided by the LTROs has done,” says Herbert Stepic, CEO of Austria’s Raiffeisen Bank International. “No other measure could have been as effective.” Investors have also drawn comfort from the ECB’s actions and their impact on the European credit markets. The refinancing operations “give the banks time to restructure and for a whole range of regulatory and political policies to work,” says Richard Ford, head of European fixed income at Morgan Stanley Investment Management in London.
Relief is not resolution, though. The ECB money has eased pressure on the banks, but it hasn’t solved their underlying problems. European lenders remain highly leveraged and still have to shrink their balance sheets, albeit at a more measured pace. London-based HSBC Holdings, one of the region’s most strongly capitalized lenders, underscored this fact last month when it sold its general insurance businesses in Asia and Latin America to France’s AXA Group and Australia’s QBE Insurance Group for $914 million.
Tighter capital and liquidity requirements are stepping up the need for banks to scale back even as the ECB pumps in money. To strengthen the sector, the European Banking Authority in December ordered banks to boost their core capital to 9 percent of risk-weighted assets by June, a standard that will require 65 banks to raise a total of €114.7 billion in capital. The effect of the tighter regulations could be dramatic. Huw van Steenis, European banking analyst at Morgan Stanley in London, estimates that the region’s banks will have to shed as much as €2.5 trillion in assets, or roughly 6 percent of the sector’s asset base, over the next 18 months.
Such pressures are restraining lending, running counter to the ECB’s hope that its liquidity injections will expand credit and revive Europe’s flagging economies. After the second LTRO, in February, central bank president Mario Draghi said the ECB expected that banks would “expand credit into the real economy.” But as Alberto Gallo, senior European credit strategist at Royal Bank of Scotland Group in London, says: “Banks won’t want to take on risky loan assets in this environment. They will prefer sovereign bonds and covered bonds which count toward their liquidity buffers for regulatory purposes.”
The preference for buying sovereign bonds suggests that the ECB’s intervention may have relieved a short-term problem at the cost of increasing long-term risk. Because banks have increased their holdings of sovereign bonds, they are more vulnerable to any renewed flare-up of the debt crisis. The dangers are increasingly evident. In March speculation that Portugal might need to follow in Greece’s footsteps and reschedule its debts sent yields on the government’s ten-year bonds climbing again, to 12.6 percent as of late last month from a recent low of 11.9 percent in February. Yields on Spanish government bonds have also edged higher in recent weeks.
Some analysts and policymakers, especially at Germany’s Bundesbank, fear that euro zone banks are becoming addicted to ECB money and might find it difficult to refinance the loans in three years’ time unless the European economy rebounds. The banks need to find sustainable sources of private funding to regain their health, analysts say. “The real test of the LTROs is whether they lead to a sustained reopening of the senior unsecured debt market,” says Nicholas Gartside, international CIO for fixed income and currency at J.P. Morgan Asset Management in London.
In short, the ECB’s interventions are hardly a panacea. As RBS’s Gallo puts it, “The LTROs are an anaesthetic, not a cure.”
WHATEVER THE LTROS’ LONG-TERM IMPACT, IT’S hard to overestimate the positive dynamic that the ECB has unleashed in the short run. The European bond markets have come alive again after the dark days of October and November. “The LTROs have far surpassed market expectations in their impact on appetite for risk,” says Michael Gower, head of long-term funding at the Netherlands’ Rabobank Group.
Banks issued a total of nearly $139 billion in senior unsecured bank debt between January 1 and March 29, more than the $86 billion they issued in the last six months of 2011, according to data provider Dealogic. Banks have also found it easier to issue covered bonds, with volume hitting $101 billion this year, more than double the amount raised in the last three months of 2011.
Crucially, even banks in so-called peripheral countries, where solvency fears are the greatest, have been able to tap the credit markets. In addition to Intesa and UniCredit, Italy’s two largest banks, borrowers have included Banca Monte dei Paschi di Siena, which had its credit rating downgraded by one notch, to BBB, by Standard & Poor’s in February because of its deteriorating assets. MPS needs to raise €3.6 billion in capital by June to meet the EBA’s standard. Still, the bank managed to issue €1.25 billion of two-year bonds at 365 basis points over midswaps in February. In Spain, Banco Popular Español, rated BBB– by S&P, succeeded in raising €750 million in early March with an offering of two-year senior unsecured bonds priced at 275 basis points over midswaps.
Growing confidence is also notably evident in the short-term interbank lending market. The three-month Euribor rate had declined to 0.794 percent in late March from 1.343 percent at the start of January; it was the lowest level of that key money market rate since July 2010. Meanwhile, U.S. money market funds, an important source of short-term bank funding, are gradually returning to euro zone banks after having pulled back sharply late last year. The funds increased their exposure to euro zone banks by about 30 percent between December 31 and the end of February, according to research by Fitch Ratings. Such exposure now accounts for about 13 percent of the funds’ $1.4 trillion in assets, down from 31 percent at the end of May 2011.
“The ECB is effectively acting as a lender of last resort, so that helps to create confidence in the euro zone’s banks,” says Mike Rees, head of wholesale banking at Standard Chartered Bank. “We would be pretty confident lending to the ‘basis’ banks — the big national champions.”
The confidence effect has spread to sovereign debt at least in part because banks have been playing the carry trade, using their 1 percent ECB loans to buy higher-yielding government bonds. ECB figures show that Italian banks increased their holdings of euro zone government bonds by a record monthly amount of €20.6 billion in January, for a total of €280 billion, while Spain’s banks bought a net amount of €23.1 billion, also a record, bringing their total up to nearly €230 billion. Seven banks, mostly Italian institutions such as Intesa Sanpaolo, Mediobanca and UniCredit, promised to buy government bonds after the second round of LTROs. By March such support had helped push Italian ten-year bond yields below 5 percent and Spanish yields below 5.5 percent. In November they had hovered dangerously around 7 percent, a level that most analysts consider unsustainable.
The LTROs do not change the fact that European banks need to raise fresh capital and shrink their balance sheets with large-scale asset sales and runoffs. The ECB loans are helping to “smooth this deleveraging process,” according to RBS’s Gallo, but not stopping it. The process could weigh heavily on an already weak economy, which the International Monetary Fund predicts will decline by 0.5 percent this year. Daniele Antonucci, an economist at Morgan Stanley, estimates that €1 trillion of deleveraging over a period of 12 months — roughly in line with what his colleague van Steenis projects — would reduce output in the 17-nation euro zone by as much as 3 percentage points this year.
It isn’t clear how many assets European banks have unloaded so far, but they have identified some €1.7 trillion of assets as nonperforming or noncore, according to a December report by Jon Daniel, director of reorganization services at Deloitte in London.
French banks have been active in looking to sell assets. BNP Paribas and Société Générale were hit hard by the withdrawal of U.S. money market funds last year, and the EBA has ordered both to raise €2.1 billion in capital. BNP Paribas announced in September that it will sell €70 billion of assets by the end of this year. The bank has put a variety of project finance and investment-grade loan portfolios up for sale, according to capital markets bankers. In March the group sold its 28.7 percent stake in French real estate company Klépierre to Simon Property Group of the U.S., booking a capital gain of €1.5 billion. SocGen has committed to generating €4 billion of cash by the end of the year through asset disposals, including €1.8 billion of performing loans. It also is seeking to sell €500 million of distressed-commercial-property loans. Last year the bank reduced its risk-weighted assets by 3.2 percent, to €332 billion, mostly through disposals of portfolios of loans, especially in structured finance, and slashed its dollar funding needs by $55 billion by disposing of U.S. mortgage-backed securities and reducing lending and underwriting in its investment banking division. Separately, Crédit Agricole sold its €3.3 billion private equity business to London-based Coller Capital in December. The bank didn’t disclose the price but said the deal would reduce its risk-weighted assets by €900 million.
Spanish banks also have been slimming down. In November and December, Santander sold its Latin American insurance business, its Colombian banking subsidiary and a 7.8 percent stake in its Chilean business, and booked a combined capital gain of $1.7 billion on the deals.
Many bankers understand the need to scale back. But they complain that the tighter capital standards promoted by the EBA are exacerbating the process and frustrating the ECB’s desire for banks to channel their cheap loans into the real economy.
Raiffeisen’s Stepic says his bank won’t be able to expand its loan book this year because it is concentrating on meeting the EBA’s requirement that it raise €2.1 billion of capital by June. As of March, Raiffeisen had reached €1.9 billion through a variety of measures, including bond buybacks. Europe’s regulators are “steering full speed in different directions,” Stepic contends. “It’s a nuisance, and there is a significant danger that liquidity could be impacted at a time when the banks need to concentrate on lending.” The CEO’s frustration is all the greater because his bank, one of the largest lenders in Central and Eastern Europe, increased lending by 8 percent in 2011. The Association of German Banks criticized the EBA’s capital requirements in December, saying, “Negative consequences cannot be ruled out, even for economic growth.” The Italian Banking Association called the rules “a great mistake that may cause a credit crunch and hurt the economy.”
The latest quarterly review by the Basel, Switzerland–based Bank for International Settlements, published in March, underscored the economic concerns. The BIS estimated that the 65 banks ordered to raise their capital ratios will have to reduce their assets by a total of €221 billion to meet their targets. Tighter regulatory standards were adding to “fears of forced asset sales, credit cuts and weaker economic activity,” it said.
A surge in bank deposits at the ECB in recent months indicates the banks’ reluctance, or inability, to step up lending and help finance an economic recovery. Overnight deposits stood at nearly €800 billion in mid-March, well above the typical level of less than €300 billion that prevailed before the LTROs. “There is still some way to go before there is a full recovery,” says Intesa’s Messina. “The next stage is a reduction in the funds deposited by banks at the ECB. I believe this money will return to the markets soon.”
The ECB doesn’t disclose the names of the depositors but says those institutions are not necessarily the ones that took LTRO money. It is significant that a cash-rich bank like HSBC disclosed that it had $130 billion on deposit at central banks worldwide at the end of 2011, compared with $57 billion a year earlier. Acting through a euro zone subsidiary, HSBC tapped the ECB for €5.4 billion in LTRO funds in February and €350 million in December.
Although it’s too early to detect the effect of the LTROs on lending, credit activity in the euro area has slowed dramatically. Lending to the private sector grew at an annualized rate of just 0.9 percent in the December-to-February period, down from 2.3 percent a year earlier, according to ECB statistics. The central bank also reported a tightening of credit conditions in its January lending survey, with a net balance of 35 percent of banks saying they were using stricter lending standards, up from 16 percent three months earlier. The BIS report found that credit was holding steady because foreign banks were taking up the slack while euro area institutions retrenched. Euro zone banks reduced credit to the private sector by 6 percent between the third and fourth quarters of last year — the drop was a much sharper 14.6 percent among banks ordered by the EBA to raise capital — but overall lending in the region declined just 0.5 percent.
The cutbacks by banks have affected even some blue-chip corporate borrowers. Last August, BNP Paribas and Germany’s Commerzbank declined to join a syndicate of banks providing $12 billion to London-based brewing giant SABMiller, even though the company was one of their clients. Italian electric utility Edipower had to turn to shareholders in December for a €1.1 billion loan after a group of banks — including Barclays, BNP Paribas, Crédit Agricole and Intesa — decided not to renew a credit facility.
Central and Eastern European countries are most vulnerable to the credit crunch because their banking systems are dominated by Western European lenders, which are pulling back to defend their core operations. BIS figures show that Western European bank exposure to the region fell by 8 percent in the third quarter of last year; analysts say this is acting as a drag on growth. The European Bank for Reconstruction and Development forecasts that economic growth in the 29 countries of Central and Eastern Europe will slow to 3.1 percent this year from 4.8 percent in 2011. The EBRD convened banks, regulators and government officials in Vienna in January to exhort participants to maintain the flow of credit to the region. “It is too early to say to what extent the LTROs have solved the problem of contraction in lending in Central and Eastern Europe, but we certainly believe that the latest round should help to boost lending,” says Erik Berglöf, the bank’s chief economist.
Other analysts worry that the banks have had to pledge so much collateral to the ECB in return for funds that they may have greater difficulty raising unsecured funds from the markets in the future. Spain’s Bankinter and Banco Popular had encumbered more than 40 percent of their assets after the two rounds of LTROs. “This is the less comfortable underbelly of the LTROs,” says David Lyon, head of financial institutions debt capital markets at Barclays in London. “This could make the senior unsecured market more expensive and more difficult to access for banks.”
Indeed, Jens Weidmann, president of the Bundesbank, worries that European banks are becoming dangerously dependent on cheap ECB funding. At a news conference last month, Germany’s central bank chief spoke of “the addicted banks” and said it was important that they be “guided away from dependency on central bank refinancing.”
Weidmann didn’t name any particular banks, but analysts cite a half dozen or so institutions that are especially vulnerable, mostly smaller domestic lenders in Spain and Italy. Banca Cívica, a €72 billion-in-assets lender with heavy exposure to Spain’s depressed real estate sector, borrowed nearly €10 billion in the two LTROs to help replace wholesale funding of €11.3 billion maturing in 2012. The new Spanish government of Prime Minister Mariano Rajoy is encouraging consolidation among the banks, and Cívica co-chairman Antonio Pulida said in February that the bank was talking to potential merger partners.
Of course, the biggest weakness of the LTROs is that they did nothing to remedy the underlying sovereign debt crisis, which is at the root of the banks’ troubles. Although government bond yields have fallen significantly since December, many analysts believe the respite is only temporary. Even after Greece’s latest restructuring, which imposed a 75 percent write-down on private sector creditors and provided €130 billion in fresh lending from the European Union, the ECB and the IMF, many analysts believe the country’s debt remains unsustainable. Rising yields on Portugal’s government bonds have fueled speculation that it too may need to restructure its debts.
In fact, by enabling banks to load up on sovereign bonds with the LTRO money, the ECB could be storing up even bigger problems if the debt crisis erupts again. “Some banks are not as safe as they look,” says Viral Acharya, an economist at New York University’s Leonard N. Stern School of Business. “Even if European regulators attach zero risk weights to sovereign bonds, the banks could be heavily penalized by the markets.”
Market conditions have to be stable for long periods if banks are to raise meaningful levels of financing without central bank help. Between 2007 and 2010, European banks raised between $500 billion and $700 billion a year in the senior unsecured debt market and $300 billion or more in the covered bond market, according to Dealogic. But as events last year made clear, worries about sovereign debt can shut off these sources of funding.
The ECB admits that it never intended for its interventions to be a panacea for the debt crisis. “The sole aim of the LTROs was to cater for the funding stress of euro area banks,” bank vice president Vítor Constâncio said in a Frankfurt speech last month.
The central bank alone can’t save a Europe of so many financial institutions and governments. As ECB president Draghi said at his latest monthly news conference, “The LTROs removed the tail risk from the environment. Now the ball is in the governments’ and the banks’ court.” • •