Austerity may be over – for the Eurozone banks

The problems of the eurozone banks have escalated sharply this year, reflected in the collapse of their share prices, and the window of opportunity for another round of publicly funded bank bailouts is closing fast. The most serious banking problem is in Italy but there are also severe problems in Portugal, continuing weakness in Spain and the largest German bank, Deutsche Bank, is in real trouble.

The issue of the banking problems will come to a head this week as the EU-wide European Banking Authority (EBA) releases the results of its annual ‘stress test’ on 51 large eurozone banks. This years round of stress tests will only test 51 banks, compared with 124 in 2014, and they will not be given a pass or fail mark as in the past. Hardly a vote of confidence.

A lot of concern is focussed on the Italian, and world’s oldest surviving, bank, Monte Dei Paschi. Some observers are predicting that unless there is spectacular bail out Monte Dei Paschi could soon be out of business, its shares have lost lost 78% of their value this year, and the fear is that if it falls into insolvency then it could bring down other vulnerable banks and start a chain reaction of bank failures.

Last week saw two out of three of the members of the institutional triad known as the Troika — the ECB and the IMF — lend their support to a taxpayer funded bailout of Italy’s banking system. So, too, did the biggest U.S. bank by assets, JP Morgan Chase. This was followed quickly by a similar call by New York-based Goldman Sachs, the finance house that has been at the centre of every major part of the banking crisis for the last ten years, the company that engineered the falsification of the Greek government accounts in order to facilitate its massive borrowing prior to the 2010 crisis, and the company which seems to operate a revolving door for so many top EU bureaucrats.

Goldman Sachs says a bail out of the Italian banks will be a bargain for all concerned, arguing that the €210 billion euros of non-performing loans (the ECB by the way says €360 billion and the amount is growing every time someone looks at it) on the books of the Italian banks could all be wiped out with the equivalent of just nine months of ECB President (and former Goldman Sachs employee) Mario Draghi’s bond purchases.

In a Goldman Sachs commentary on the plight of the Italian banks Francesco Garzarelli argues that with the ECB buying up €120 billion per year of outstanding Italian government bonds as part of its quantitative easing scheme, “by the time QE is over – not sooner than end 2017, on our baseline scenario – around a fifth of Italy’s public debt will be sitting on the Bank of Italy’s balance sheet”. He goes on to argue that bringing the entire net stock of bad loans onto the government’s balance sheet would be equivalent to ‘merely’ nine months worth of Italian government bond purchases by the ECB. With just days for authorities to come up with a plan to inject capital into Monte dei Paschi before the stress tests results are known, Goldman adds that some form of “state intervention is both “likely and, at this late stage, desirable”.

Even a massive bank bail out program it will do little to remedy Italy’s chronic financial ills, which include a stagnant economy, a public debt that exceeds 130% of GDP, a currency that is too strong, a zombified housing market, 35% youth unemployment, and entrenched political corruption. As The Guardian‘s Larry Elliot writes, Italy’s non-performing loans reflect a “non-performing economy.” They are “the symptom of the problem, not its cause.” A massive bail out will just buy a little more time but not solve the root cause of the banking malaise, as the situation in Portugal attests.

If bailing out banks were the perfect cure-all to a country’s financial ills, why is Portugal’s financial sector seemingly in need of fresh funds, just five years after receiving €78 billion in bailout money from taxpayers elsewhere? Portuguese banks, already undercapitalised and loaded with bad debt, are bracing for heavy losses from Lisbon’s so far unsuccessful attempts to sell Novo Banco, the lender salvaged from the collapse of Banco Espírito Santo.

Estimates of the potential bill facing banks, which finance the resolution fund that bailed out Novo Banco in 2014, range from €2.9 billion to €3.9 billion. Some bankers are even doubtful that the rescued lender will attract any acceptable offers, leading to its possible break-up or liquidation. The sale of Novo Banco is among critical decisions that will shortly determine the future shape of Portugal’s banking industry, which the International Monetary Fund has linked with the problems facing Italian lenders as among potential risks to global growth.

Lisbon and EU authorities are locked in tough negotiations over plans to recapitalise state-owned Caixa Geral de Depósitos, Portugal’s largest bank, with conflicting estimates of its capital needs ranging from about €2bn to €5bn. The Bank of Portugal and Lisbon’s eight-month-old “anti-austerity” government are also calling for a “systemic solution” to deal with more than €30bn in bad debts and problem assets, adding to other calls for public bailouts of troubled EU banks. In a recent report, Barclays warned that Portuguese lenders could need up to €7.5 billion to resolve a “systemic banking crisis”.

“Some banks are in need of a large capital injection,” said Antonio Garcia Pascual, chief European economist with Barclays. “This means any material losses from the sale of Novo Banco [the supposedly good bank spawned from the loins of the now-defunct Espirito Santo] could end up having to be met by the sovereign [i.e. taxpayers], as the capacity of Portuguese banks to absorb them is rather limited.”

Portugal’s continuing banking problems, like Italy’s, are the result of of its continuing economic problems. Its deficit continues to exceed EU euro system limits (a deficit of 12.4 billion Euros in 2014 and 7.9 billion in 2015 has meant that like Spain it is currently under threat of EU fines) which means that the national debt (129% of GDP) has grown too. In current prevailing conditions a rising national debt is much less likely to cause yeilds to spike simply because Mario Draghi and the ECB are hoovering up so much of it. So far the ECB purchase of 19.1 billion Euros of Portuguese government debt has meant that it can continue to borrow relatively cheaply (its ten-year yield is 3.06%). But as to repaying any of it well that looks ever further away and without ECB support then Portugal looks on its way to insolvency unless it can finally find some sustained economic growth. Having kicked the deficit can down the road for a while the EU is now threatening to fine both Portugal and Spain for ‘excessive spending’. That should help. As should the German led campaign to end or at least significantly reduce the ECB’s quantitative easing program, the only thing holding down yields on peripheral eurozone bonds.

As ever the German position is that if everybody follows the rules and accepts the full consequences of their actions then everything would work out for the best, although if it looks like the Deutsche Bank is really in danger of going down they may change their tune. Deutsche Bank issued a warning today that further cost cutting might be needed as profits tumbled in the second quarter amid low interest rates and volatile markets. Net profit at Germany’s biggest lender fell 98% to €20m (£16.7m), compared with €796m for the same period in 2015. Chief executive John Cryan said: “If the current weak economic environment persists, we will need to be yet more ambitious in the timing and intensity of our restructuring.” Revenues were down 20% to €7.4 billion. Deutsche Bank’s value has nearly halved since the beginning of the year, with its shares having fallen 43%. In June, the International Monetary Fund said that of the banks deemed large enough to pose a threat to the financial system should things go wrong, Deutsche Bank was the riskiest.

In Spain, meanwhile, the banks are not yet begging for public money, but there are ominous signs on the horizon. In a desperate bid to placate the markets, the country’s fifth biggest bank, Banco Popular, recently announced layoffs of up to 3,000 workers, but to little avail. Arguably the most exposed bank to Spain’s crisis-drained real estate sector, Popular’s shares continue to languish at a historic low of €1.22 a piece; two years ago they were worth close to €6.

Even for Spain’s biggest bank, Santander, the problems are stacking up, with significant exposure to the turbulent financial markets of Brazil and the UK, and to subprime auto-lending in the US. And Spain’s second largest bank, BBVA, is mired down in Turkey, where it owns 40% of the country’s third biggest bank, Garanti. BBVA’s Turkish operations provide a larger share of its revenues than all of its South American operations combined. The bank’s management has already warned Spain’s regulators that “unfolding events in key emerging markets” could have a “significantly adverse effect on the group’s business, financial situation and earnings,” which are scheduled to be published in a few days.

As the problems mount in Southern Europe (with Greek banks still festering), it is highly likely that taxpayers will be once again, directly or indirectly, via governments or the central bank, be handed the bill for bailing out bank bondholders. The IMF, the ECB, Goldman, JP Morgan Chase, and other banks that own these bonds are already firmly on board. Italians who own these bonds are on board. Hedge funds who’ve by now bought these bonds are on board. Everything is set on go. Now its up to the Germans.

Following the money

Of course there is the tricky question of where all the new bailout funds will actually go and into whose pockets they might eventually drop, as recent events in Slovenia demonstrated.

It all began with an early morning police raid. On July 6, Slovenian Police, acting on an insider tip, raided the headquarters of the country’s central bank, the Bank of Slovenia, and seized information stored on the bank’s internal network. It also raided the headquarters of the major state-owned bank Nova Ljubljanksa and the local offices of international accountancy firms (and prolific enablers of corporate misbehavior), Ernst & Young and Deloitte.

The police were investigating allegations that some “legal entities” had abused their office in valuing equity at Nova Ljubljanksa during its bailout by the state in 2013. €257 million is alleged to have been misappropriated, during the €3.2 billion bailout of the banks.

The action provoked a furious backlash from ECB chairman Mario Draghi, who wrote the following in a strongly worded letter:

Both Slovenia’s central bank and Finance Minister Dusan Mramor, who unexpectedly resigned on July 13, sided with Draghi, arguing that the probe represented an attack on the central bank’s institutional independence. They both called on Prosecutor General Zvonko Fiser to conclude his probe into the €3.2 billion recapitalization of state-owned banks as swiftly as possible.

In part they are right: the ECB is directly interfering in the actions of Slovenian authorities, prosecution, and courts. But where they are wrong is in their belief that these institutions enjoy any kind of procedural independence when it comes to investigating the actions of Slovenia’s central bank in its bailout of the financial system. Such powers were signed away a long time ago by Slovenia’s government — and the governments of all other Eurozone member states.

The ECB and all of its affiliated national central banks are, by law, above the law of national jurisdictions and answerable only to the European Court of Justice, provided they are fulfilling the functions and responsibilities assigned to them by EU law. This is particularly true in relation to bailouts of Europe’s financial institutions. Similarly the Luxembourg-based European Stability Mechanism (ESM), which was founded on September 27, 2012, as a permanent facility within the ECB to provide bailouts to countries that are in distress. It currently has an authorised capital limit of €700 billion, though that can be expanded at any time by the board of governors, and individual Eurozone member states are “irrevocably and unconditionally” required to cough up the funds.

The institution has already provided €136.3 billion in bailout funds to three Eurozone members — Cyprus (€9bn), Greece, (€86bn) and Spain (€41.3bn), but that amount will almost certainly increase in the coming months if the calls are heeded from ECB, among others, for the creation of a European TARP fund to mop up the non-performing loans clogging up the banking systems in Italy, Portugal and Greece.
If a massive bailout program starts then tens of billions of newly created digital euros will flow from Frankfurt and Luxembourg to the central banks of Italy and Greece, and from there onto the balance sheets of distressed banks throughout the two nations. With such huge sums of money flowing between institutions of questionable repute and under conditions of virtual secrecy, the potential for fraud or outright theft on either or both sides of the transactions is huge, especially given blanket immunity of many of the institutions invloved.

Under Article 32 of the consolidated ESM Treaty:

To hammer the point home, Article 32 further states that:

The same Article 32 also points out that the “archives of the ESM and all documents belonging to the ESM or held by it, shall be inviolable.”

It’s not just the ESM’s property, funding and assets that are inviolable; so, too, are its employees. From Article 35:

The above clauses provide the ESM and its employees with not just complete immunity from national law, but total impunity.

If €257 million could be misappropriated in the relatively small Slovenian bank bailout, almost 10% of the total funds released, imagine how much money could be made to disappear in a bailout of Italy’s banking system!

It looks like austerity may be over – for some.