Europe: "The Flaw"
We have posted various extracts from this piece from Credit Suisse previously. We will post from it again, because, to loosely paraphrase Lewis Black, it bears reposting... especially in the context of the latest and greatest Greek "bailout" (of Europe's bankers), which incidentally, will achieve nothing and merely bring the country one step closer to a military coup and/or civil war.
The market is essentially proceeding on the assumption, as we see it, that banks’ capital requirements can be met organically, through earnings and deleveraging. We want to be very careful about leaning too hard on this; we have insisted for a long time that the banking system needs to shrink, and that the capital markets would grow to match. But this is not a short-term process and cannot be, if it is to remain orderly.
The 2011 consensus range of bank capital requirements was € 100bn to €400bn; the log. average, €200bn, always seemed like a sensible estimate to us. The market is proceeding on the assumption that the need has all but gone away; many estimates now centre on €50bn. Such numbers strike us as ridiculous; the Greek banks alone are absorbing that (see above) and Anglo-Irish absorbed €30bn. This is (yet) another of those cases where a number is small until it is needed, at which point it grows.
But the market has made these moves in thinking despite our long asserting the premise that liquidity cannot cure a solvency issue, and it is liquidity that has been the big change.
Partly, “the paradox of thrift”. Each bank individually can credibly plan to delever, but collectively the system cannot. But even if the inherent contradiction is recognised, it is hard to act on immediately.
Debt is no cure for debt. What it can do is prevent a self-fuelling Fisher-style debt-deflation and it is clear that the LTRO has at least to some extent achieved that. And it can buy time such that, if the basic business model is restored, solvency can be earned. But we are not sure the business model has been restored; far from it. Here again, our caution and outright mistrust needs to be tempered, and at least patient. But the apparent widespread notion that the LTRO is a game-changer simply does not wash in our view, because of our premise. Game-saver (no Fisher); yes. Game-extender, which makes it a potential gamechanger [Let’s torture a football analogy. If you are down at full time, injury time at least give you a chance, but cannot guarantee a win, unless for a potentially infinite period of your choice. Not every game can be France England 13 June 2004; 0-1 at full time, 2-1 after injury time as Zinedane Zidane proved that football is a game of two halves and two minutes. But every game has an exante chance to do this; even Germany-England, 1 September 2001, which is the rough equivalent of the situation facing the European banking system, in our view; 5-1 at full time with approximately four minutes added.]; yes. Outright game-changer; no.
So what’s the flaw?
The flaw is that, even in 2012, we retain respect for markets. Unfettered, they are not the tool of choice for resolving the current situation but we see it as essential to work with them and harness their power, rather than against them, as we discussed in Twelve Steps.
In Greece it is now clear that the process of avoiding a credit event for the past 21 months has been ruinously expensive. Frustrate the markets (again, individuals making rational, fiduciary decisions, not some conspiracy pursuing an agenda) and they will find a way around the frustration, in our view; in the meantime, costs will increase due to the inefficiencies created, as has happened in Greece.
The result that we now expect in the European banking system is in our view rather beautiful.
The Basel Accords have a patchy track record – to put it at its most generous – and the EBA has almost no track record at all and as we see it, even less credibility in the eyes of the market. The market is fickle (and in this situation self-fuelling, so it must be tempered; indeed it has been by the LTRO), so it cannot even trust its own estimates (as stated above, they are all over the map). But it cannot be frustrated in seeking comfort on such an important issue as restoring trust in the biggest banking system in the world, in our view.
In the banking system just as in Greece, the rescue funds are coming in at a senior level. There are therefore two kinds of bank; those with the market’s full confidence, which will be able to fund at a “senior” but partially subordinated level, and which can repay everything without question [Or, are seen as being able to even at sub level. Either they take advantage of the very attractive ECB funding on offer or issue covered bonds, for example, with no risk or entering the self-fuelling subordination loop.] and those who cannot. The price of time to the latter is ever-further subordination in a self-fuelling circle. Over time, the market will empirically, and with efficient pricing, weigh the liability side of the balance sheet versus the asset side, less haircuts (so haircuts become the de-facto capital requirement), tranche by tranche, maturity by maturity, and see what happens. If there is any insolvency in the European banking system, it will eventually appear, independent of Basel or EBA requirements (which may still becoming binding, of course). But it is hard to see how it appears before some time has elapsed. In this environment, competition for retail deposits, of which the European banking system is chronically short, largely because of its size, will become ever more intense.
Inevitably, due to the mark-to-market nature of repo, the banking system is now even more sensitive to mark-to-market, further baking volatility into the cake. This reinforces our idea that the ultimate arbiter of bank capitalization is the senior unsecured market.
We suspect that organic earnings retention cannot be the solution. According to ECB data, the aggregate post-tax profits of the banks of all EU27 countries were €46.8bn in H1 2011, more than 100% accounted for by large banks (medium-sized banks lost $1.8bn). This pattern has been persistent since the unusual 2008 year (see Exhibit 2).
It is impossible to extract trends from this table, but it clearly does not invalidate a hypothesis that weaker banks (where by definition capital needs are concentrated) might take a long time to earn the requisite capital. Even if capital needs were heterogeneously distributed, which they are not, a period of weak profitability and capital needs at the upper end of the spectrum would suggest a long period. And during that period, we salami-slice balance sheets. Watch your fingers.