How not to restore confidence in eurozone banks
The insolvent Spanish banking system is being bled dry by depositor outflows. Spain has asked and the the EU has agreed to recapitalize its banks in order to enable the ECB to keep lending against the run. There is debate concerning the need for a eurozone deposit guarantee to restore confidence and end the runs on the peripheral banks. Depositors in the peripheral countries face the risk of individual bank failure as well as the risk of a forced redenomination into domestic currency.
Because banks are highly levered, inherently illiquid, and analytically opaque, depositor confidence can only be maintained by the expectation of both a lender of last resort as well as a state rescue authority. Such mechanisms are the reason why banks never default on their deposits and are instead rescued (bailed out). Throughout the entire financial crisis of 2007-12, no eurozone bank, no matter how tiny, has defaulted upon its deposits.
The state mechanisms that backstop depositor confidence depend upon the willingness and the ability of the state to rescue banks. This has now been called into question in the eurozone because a number of states lack the resources required to maintain systemic solvency, which the ECB requires as a precondition for lending. That problem is most acute in Spain at the moment, hence the hastily-agreed EUR 100 billion bailout.
Governments rarely offer blanket deposit guarantees, but they are understood to exist implicitly. Because regulators want investors to provide a degree of market discipline, such as credit ratings and other measures of solvency, they create sufficient constructive ambiguity around bailouts for markets to punish weaker banks. This requires a dance between depositor discipline, on the one hand, and market confidence on the other. No regulator can realistically expect the retail depositor to add bank analysis to her other daily responsibilities.
The European Commission has just released its long-awaited bank resolution plan. It calls for bondholders (and possibly institutional depositors) to be wiped out under certain circumstances (in the future). This comes in the middle of the greatest banking crisis in modern European history. At the very moment when Europe is moving heaven and earth to restore market confidence in its banks, the commission has comes out with a plan to allow banks to default upon their senior debt and possibly even uninsured deposits. This means that now potential buyers of bank obligations face the risk that, even in the event of a bank bailout, they will be wiped out.
Therefore, an analyst of European bank bonds (let’s say Spanish bank bonds), must analyze (1) the bank’s solvency; (2) the government’s solvency; (3) the likelihood that the government and/or its banks will be recapitalized by the EU in the event that the government is insolvent; and (4) the risk that in the event of a recapitalization, losses are imposed upon bondholders. (I might add that bank bondholders have already been subordinated to credit extended by the ECB and the IMF.) One must ask: would any thinking fiduciary consider adding such a security to his clients’ portfolios except as a pure speculation with commensurate speculative yield?
How are such Spanish bank bonds trading today? Weaker names, such as Bankia, are trading as deep junk. Bankia is in the process of receiving EUR 19 billion in recapitalization funds from the state. Despite that, its bonds are trading at an implied Caa1, or at risk of default. The market has no confidence in Bankia's bonds, despite the prospective bailout.
It appears that Europe has two desires: (1) to restore confidence in the eurozone banking systems; and (2) to ensure that weak banks in weak eurozone countries will never regain market access, and will thus become permanent wards of Europe. I am beginning to understand Mario Draghi’s frustration with his European “partners”.