The European Central Bank's recent LTRO programs have effected a significant increase in the amount of encumbered assets -- those pledged as collateral in repo transactions, central bank funding operations, and covered bond issuance as lenders increasingly demand over-collateralized borrowing arrangements to protect against credit risk -- on balance sheets across the pan-European banking system.
According to Barclays, average encumbrance across banks has risen dramatically to around 21% of assets. German banks, which are actually less encumbered than in 2005, and those in Finland, which are roughly around the same levels, are the lone exceptions in the eurozone:
The effect this is having -- which has been noted many times at this point -- is that as banks continue to trade their eligible collateral with the likes of the ECB, repo lenders, and covered bond markets in exchange for short term funding, they are increasing the loss given default (LGD) to unsecured creditors (those who have extended loans that are not collateralized) who face a shrinking pool of recoverable assets and are therefore less willing to extend credit at lower rates.
Barclays has also arrived at the conclusion that unsecured debt will eventually be viewed no differently as subordinated debt as it's likely that LGDs in the European banking system will approach 100%, especially if laws are passed as part of regulatory reform measures to strengthen depositor protections. Here is their reasoning:
There isn’t a statistically significant sample size of recent European bank failures on which to estimate LGDs more accurately. But looking at the US experience points to LGDs for unsecured investors in banks being high. Of the 422 bank failures in the US since 2008, all but one forced a loss upon the FDIC (Figure 10). Since the FDIC only has to pay claims if assets are insufficient to cover deposits, this implies a 100% LGD for unsecured creditors in almost all cases.
However, applying the 100% LGD at US banks to Europe is probably a step too far. Depositor preference laws in the US means that depositors have to be made whole before bondholders can be repaid – meaning that the LGD for the unsecured investor is increased. But since approximately 75% of US banks’ liabilities are in the form of deposits, we can extrapolate that the LGDs at US banks, in the absence of depositor preference laws would be c50%.
Depositor preference is not yet law across most of Europe but would clearly be a further headwind for bank funding costs if they were to be introduced. If depositor preference laws were adopted globally, Figure 12 shows that the amount of unencumbered assets available for unsecured investors would fall dramatically, particularly for more deposit-rich franchises. To be clear, this takes the size of outstanding senior unsecured bonds relative to unencumbered assets from Figure 9 and then nets out deposits (including retail bonds).
Figure 12 amply illustrates the knock-on effects to bank funding of implementing depositor protection in jurisdictions within the eurozone that currently don't offer it (everywhere except Germany). So, either depositors outside of the safe German banks will be left open to subordination in the event of default in the eurozone -- and thus capital flight as evidenced in widening TARGET2 imbalances will continue -- or depositor protection laws will essentially wipe out the market for bank funding via senior unsecured debt in Europe, thereby continuing to drive de-leveraging as this structural shift in funding is sorted out and continually increasing dependence on the likes of the ECB for funding. Barclays on where this leads:
What are banks’ other options if unsecured funding costs don’t come down to economical levels? Terming out unsecured funding offers some respite in reducing roll-over risks for the banks but does little to offset structurally higher funding costs from higher LGDs. So banks may try to replace wholesale funding with deposits. But this is a slow process and becomes difficult to execute if it’s a system-wide issue. This suggests that there could be on-going pressures on banks to reduce wholesale funding reliance via balance sheet shrinkage – the very thing that the LTRO was designed to prevent.
Deposit flight from the periphery to Germany has been observed for quite some time now as peripheral banks are increasingly viewed by depositors as unsafe. Europe can choose to address this by enacting greater protection for depositors in countries other than Germany, but doing so will likely cripple the funding market for eurozone banks further and increase reliance on the ECB, whose over-collateralized refinancing programs are driving the de-leveraging they were ostensibly designed to prevent. It's a tough spot.
Greece is up; Spain is on deck.