The entire euro system faces failureJun 8, 2023·Alasdair Macleod
In these dogdays of summer, there is a new complacency over the financial and economic status of the Eurozone. Inflation is down, bank shares have rallied, and the end of further rises in interest rates is in sight.
The lull in bad news conceals a deteriorating situation. In common with other markets, Eurozone bond yields are rising, and banks are now visibly trying to reduce their excessive balance sheet leverage. This is bound to lead to credit shortages in the coming months, maintaining or even driving interest rates higher. Contracting credit could lead to funding dislocations for highly indebted Eurozone governments, all mired in debt traps.
Presiding over all this is a clueless ECB, long on rhetoric and short on economic nous. Furthermore, even though it has reduced its balance sheet by a trillion euros, the hidden losses in the euro system wipes out its equity many times over. How can it recapitalise itself, and how can it underwrite depositors in a deteriorating commercial banking system?
It is a recipe for an entire systemic failure.
Definitions: The Eurozone is comprised of the European nations which have adopted the euro as their currency. The euro system is the combined network of central banks, comprising the ECB itself and the national central banks.
There is good news on the inflation front for some countries in the Eurozone. CPI inflation in Spain is back down at 2.9%, in Germany it has dropped to 6.1% from 7.2% in April, and in France it is down to 5.6%. Annual rates are falling, mainly because large price rises are dropping out of the back end of the statistics. But with energy prices easing substantially (natural gas is down 74% year-on-year, and heating oil down 44% both in dollar terms) mainstream economists are increasingly confident that the declining trend will continue, and that the inflation monster has been slain.
Instead, their concerns are now more about the prospect of recession, with hopes for a decline in interest rates now that inflation is becoming yesterday’s story. In this context, many are looking at money supply. And in Q1 this year, Eurozone M3 has contracted by a paltry €140bn since last September to a little over €16 trillion. But in another statistic, the euro system’s network comprising the ECB and national central banks has reduced its collective balance sheet by a little over €1 trillion over the same timescale.
Therefore, monetary tightening has been at the central bank level, reducing holdings of euro area government bonds, and reducing commercial bank assets accordingly. Balance sheet contraction has not been much at the expense of bank deposits, which are the largest component of broad money supply M3 statistics. Instead, the banks collectively will have reduced other liabilities, at the “wholesale level” by which we mean repo and interbank markets and other sources of funding to match the reduction in their reserves in the euro system.
Monetary economists point out that adjusted by CPI inflation, real money supply is contracting severely. Their common view is that the slowing down of monetary growth is a clear indication of interest rate overkill, leading to a recession. They are correct in this conclusion, but not necessarily for any reason other than the empirical evidence that they cite. The reason this is correct is that nominal GDP is simply the sum total of eligible transactions over a defined period recorded in the statistic. Bank credit measured by deposits is the stock of currency and credit for all economic activities, including GDP and non-GDP items. Assuming there is little change in the level of non-GDP activities, therefore a decline in bank deposits must feed directly into a decline in GDP.
But the decline in Eurozone bank balance sheets is not so much in deposits, but related to the euro system’s quantitative tightening, simply because the reduction in bank reserves held at the central banks is not in public circulation. At the margin, some deposits may be destroyed by the reduction of bank balance sheets, which probably explains the miniscule drop in the M3 total. That being the case, we should conclude that current concerns about a recession forecast by slowing GDP are for the moment overdone.
It is worth making this point in order to establish where the Eurozone is positioned in the cycle of bank credit. While the monetarists don’t necessary understand the drivers behind their mathematical approach, we can simply assume that until the risks of bank balance sheet leverage are properly addressed, bank credit in connection with GDP activities will stagnate or even contract, taking economic activity into contraction as well.
The condition of the major Eurozone banks
Confirmed by the leverage of the Japanese banks, a consequence of negative interest rates has been excessive balance sheet leverage for the Eurozone’s GSIBs — the global systemically important banks. Undoubtedly, this is due to credit margin compression because of the ECB’s interest rate policies and the attempt by these banks to maintain shareholders’ profits. Many years of declining interest rates and the lack of stimulative effect on CPI inflation will have led to a lazy conviction that the ECB could continue to keep interest rates suppressed at or below zero without inflationary consequences. Therefore, there was no significant danger expected of an increase in interest rates, lulling bank executives into a belief that record levels of bank leverage were justified. Furthermore, bankers act as a cohort, swapping views in bankers’ clubs and other forums in all the major banking centres. And if Bank A is successfully maintaining its profits having taken its balance sheet assets to equity leverage to twenty times, then the pressure is on Banks B, C, D, and E to follow suit.
This competitive groupthinking drives every bank credit cycle to dangerous levels until lending conditions change. Usually, there is evolving evidence which leads bankers to believe that lending risks are increasing, rather than a specific event. And when that happens, the banking cohort always acts in synchrony, trying to contract the asset sides of their balance sheets. That was what happened at the peak of the last lending cycle, when the risks from liar loans backing collateralised loan obligations suddenly dawned on them. This time is somewhat different with the event of sanctions against Russia being a bankers’ wake up call in Europe, because of the impact on energy and food prices and the write-offs they had to make on Russian exposure.
In fact, interest rates measured by bond yields along the maturity curve were already rising before the Russian sanctions were imposed, and consumer prices were beginning to rise as well. But seemingly complacent bankers swallowed the transient inflation story being promoted by all central bankers at that time. Subsequently, they have learned that there were increasing lending risks both for financial and non-financial activities. And while consumer inflation is subsiding, in unison their inhouse economists are now forecasting a deteriorating business outlook.
The consequence is that bank credit is no longer expanding, and with recessionary conditions developing where they are being renewed, loan facilities to businesses come with higher borrowing costs. Initially, this leads to improved lending margins, and the benefit to bank profits is reflected in the following chart of a diverse ETF of European bank shares.
Improved lending margins are encouraging some security analysts to remain positive. This is from a ZeroHedge article only yesterday[i]:
Some investors are keeping a positive view. “We still have a bit of a tilt toward European banks as we think the full impact of higher interest rates is yet to feed through,” says Helen Jewell, deputy CIO for BlackRock EMEA Fundamental Equities. She acknowledges the need to be selective given recent banking sector volatility.
From the bear market low in March 2020, the ETF in the chart above has doubled. But this is an initial effect, which only serves to justify further reductions in balance sheet leverage while maintaining a targeted level of profitability. It does not encourage banks to increase their lending. With all banks driven by the same motivation, we can observe a cyclical factor developing with lending growth stalling followed by contracting bank credit and stubbornly high interest rates reflecting scarcity of credit.
However, reducing balance sheet leverage is not simple, because once created deposits across the entire banking system cannot be easily reduced. And on the asset side, denying businesses working capital threatens to bring about their insolvency, increasing non-performing loans and debt write-offs, whose effect on shareholders’ equity is magnified by the asset to equity ratio. The lines of least resistance are withdrawing from future commitments such as mortgage finance offerings and selling down government bonds with maturities beyond a few years substituting them with short-term treasury bills. With interest rates having increased and yield curves now negative, selling longer maturities makes sense from a profit and loss account perspective but often involves significant write-offs on balance sheets, as the failure of Silicon Bank in America demonstrated.
As shown in the charts above and in common with those elsewhere, Eurozone bond yields are already rising again and undoubtedly this trend reflects banks de-risking their balance sheets at a time of supposedly declining inflation. But there are anomalies, with the yield on Greece’s 10-year government bond at 3.8%, compared with the US Treasury at the same yield. Portugal is at 3.2%, Spain at 3.5%, and Ireland at 2.86%. The likely explanation is that foreigners have been selling the larger bond markets because that is what they own. And when foreigners start selling, domestic holders almost always follow. A funding crisis for some or all of these nations is set to return when systemic risks are properly addressed.
Collectively, Eurozone banks are having their deposits at the central banks (their reserves) being reduced for them, but those are not counted as deposits in money supply. Banks actively reducing liabilities other than those to their shareholders can only be initially achieved at the expense of liquidity, such as by reducing repo activities, or not novating deposit liabilities for foreigners withdrawing deposits to sell euros in the foreign exchanges. In short, other than reductions in balances because of the ECB’s quantitative tightening, overleveraged banks are more or less trapped. And it explains why bank directors in the large overleveraged banks have not addressed the risks faced by their shareholders.
The current leverage position for Eurozone GSIBs is illustrated in the table below.
Total shareholder leverage allowing for price to book values illustrates the extraordinary riskiness of the Eurozone’s global systemically important banks. These are designated GSIBs under Basel rules and are required to retain liquidity buffers to alleviate counterparty risk due to their international counterparty exposure. But while implementing a net stable funding ratio to protect liquidity, Basel 3 pays scant attention to the responsibilities of bank executives to their shareholders, and it shows in these figures.
Followed by Deutsche Bank, Société Generale has the lowest price to book at 27.5%. In other words, by valuing these equities at enormous discounts to balance sheet equity the market is telling us that the chances that Société Generale and Deutsche Bank will fail and have to be bailed in or out are significantly higher than their chances of survival. At these ratings, their shares represent no more than option money on their continued existence. But putting the market view aside, we see that balance sheet gearing for all the GSIBs is exceptionally high, with the sole exception of Unicredit’s which is not much higher than the upper limit of 10—12 times usually seen at the peak of bank credit cycles. And in the case of Credit Agricole this ratio is stratospheric. Bank regulators cannot be totally blind to this situation, in which case they are deliberately suppressing information on bank solvency in the interest of not being directly blamed for failing in their duty.
There is considerable variance in market ratings for these banks, with price to book ratios not necessarily reflecting balance sheet leverage. We can put this down to several factors, such as the mix of financial and non-financial loan business, off-balance sheet exposure in derivatives, the liquidity of liability funding, and creative accounting. Therefore, the risk exposure as shown by balance sheet ratios is probably less of a guide to shareholders than price to book ratios.
Nevertheless, the failure of one of these banks would have unimaginable consequences for the others, due to counterparty risks within the Eurozone and beyond. They all take in each other’s washing, notably in derivative and repo obligations. The rating for Dutch lender ING, whose rating is out on a limb, should reflect systemic risk in the other GSIBs however sound the bank might appear to be.
TARGET2 and the repo problem
The chart above illustrates the imbalances in the TARGET2 settlement system between the national central banks and between them and the ECB. They have reduced slightly in recent months but are still extremely high for Germany and Luxembourg on the credit side, and the ECB, Spain, and Italy on the debit side.
Germany and Luxembourg between them are owed a net €1.377 trillion. Italy and Spain between them owe the system €1.13 trillion. And the ECB owes the national central banks €370.5bn. The effect of the ECB deficit, which appears to arise from bond purchases conducted on its behalf by the national central banks in their local markets, is to artificially reduce the TARGET2 balances of debtors in the system to the extent the ECB has bought their government bonds. Putting the ECB’s bond purchases to one side, the combined debts of Italy and Spain to the other national central banks could easily exceed €1.3 trillion.
In theory, these imbalances should not exist. The fact that they do and that from 2015 they have been increasing is due partly to accumulating bad debts in the wake of the European banking crisis, when Portugal, Italy, Greece, Spain, Ireland, and Cyprus had difficulties financing their debt or in bailing out their banks.
Local regulators had been incentivised to declare non-performing bank loans as performing, so that they can be used as collateral for repurchase agreements (repos) with the local central bank. This has had the effect of reducing non-performing loans at the national level, encouraging the view that the bad debt problem had been dealt with, particularly in Italy and Spain. But the problem was merely removed from national banking systems and lost in the euro system. And the fact that there is no official explanation for why the Bundesbank has ended up such a large creditor of TARGET2 counterparties probably led to the resignation of its President Jens Weidmann in 2021 on a matter of principal.
Demand for collateral against which to obtain liquidity has led to significant credit expansion, with the repo market acting not as a marginal liquidity provider as is the case in other banking systems, but as an accumulating supply of raw credit. This is shown in Figure 4, which is the result of a survey of 61 offices of leading institutions in the euro system conducted by the International Capital Markets Association.
The outstanding total for this form of short-term financing grew to €10.37 trillion in outstanding contracts by December 2022. The collateral includes everything from government bonds and bills to pre-packaged national commercial bank debt. According to the survey, double counting is minimal whereby repos are offset by reverse repos. This is important when one considers that a reverse repo is the other side of a repo, so that with repos being additional to the reverse repos recorded, the sum of the two is a valid measure of the size of the market. The value of repos transacted with central banks as part of official monetary policy operations are not included in the survey but may have declined somewhat from the very substantial levels noted in previous surveys, due to the reduction in bond collateral on euro system balance sheets. But repos with central banks in the ordinary course of financing are included.
At end-December, the net balance between repos and reverse repos was net funding for banks of €617bn. This represents the additional liquidity provided to commercial banks in the repo market, some of which will have come from the shadow banks. But as the ICMA survey points out, this figure could reflect changes in funding from central banks as noted above. Nevertheless, at a time when the expansion of euro money supply has slowed it appears that repo funding of bank liabilities is an alternative source of liability funds, confusing the overall picture.
In recent years, the expansion of the euro repo market has been a significant feature, accompanying declining and negative interest rates. Before repos, wholesale money markets were comprised of interbank lending, which was uncollateralised. Accordingly, imbalances between banks were relatively minor, a few million at most. Repos have come about because banking business has trended towards larger day-to-day imbalances, as banks have shifted from loan creation to purely financial activities particularly in derivatives, market making, and bond trading. Banks holding high quality collateral have been happy to commit it to a repo transaction, raising cash for further financial speculation. To that extent, the growth of the repo market has been consistent with bankers dismissing systemic and market risks from their minds. In an increasingly financialised Eurozone, balance sheet expansion has been into purely financial functions for which repos have provided the liquidity. Now that commercial banks are transiting into fear of excessive leverage with a changed interest rate environment, repo markets are likely to contract globally revealing strains in the entire banking system, and driving down financial asset values.
Euro repo markets differ materially from dollar repo markets in the US, which uses high quality collateral only (US Treasury bills and bonds and agency debt). In Europe, the variations in collateral quality for tri-party repos are shown below. Tri-party repos are arranged through an intermediary, such as a broker. They are part of the larger repo market but reflect its trends.
Unrated bonds and bonds rated BBB and worse made up 42.3% of the total collateral in December 2022. This exposes the market to increasing risks if interest rates rise further, or the Eurozone economy heads into recession, further driving its contraction.
Besides a minority of banks searching for liquidity in these difficult times, it would appear likely that the commercial banking cohort will reduce its involvement in repo business in future. The rate of growth in 2022 was already slowing. Reverse repos, whereby a lender takes in collateral against cash credit, are likely to become more difficult to source as only high quality loan collateral (mostly short-dated government debt) is likely to be accepted and lower quality collateral rejected. For weaker banks, repo funding could effectively become cut off, leading to a liquidity crisis in the Eurozone’s commercial banking network spreading, particularly if a bank finds it difficult to retain deposits.
In the short term, that is likely to be resolved by national central banks stepping up their liquidity facilities. We have yet to see the latest ICMA survey (which is being conducted this week to be released in September), but it will be interesting to see how it compares with the December 2022 survey and if a contraction is underway.
The entire euro system is insolvent
In common with other major central banks, the ECB and its network of national central banks, together the euro system, have accumulated government and other bonds through quantitative easing. The extent to which it has boosted the size of the euro system balance sheet is shown in the chart below.
Having hit a high point of €8,828 billion exactly a year ago, The ECB and national central banks’ assets have declined to €7,713 billion. Most of the increase since the last financial crisis to the peak has been through what the ECB calls asset purchase programmes, but otherwise known to us as quantitative easing. The decline in total assets will have been achieved by allowing short-term assets to mature and for the funds to be not reinvested but the liabilities to commercial banks reduced.
Nevertheless, on the remaining securities holdings totalling €5,067 billion currently, there are significant losses on a mark-to-market basis. Assuming an average maturity of five years, and an average rise in yield from 0% to 3% on Eurozone government bonds, over the last year the losses in the euro system amount to about €700 billion. This is nearly six times the combined euro system’s equity.
To assume that this is not a problem because the ECB can always print euros is complacent. The only hope for the Eurosystem is for bond yields to decline, and therefore values to rise restoring balance sheet integrity. But for now, yields are rising. And with commercial banks restricting credit expansion, the outlook is for high bond yields to persist. At some stage, the assumption that inflation will return to target and that interest rates and bond yields will decline will be abandoned, and the recapitalisation of the entire euro system will then have to be contemplated.
It will not be easy. Undoubtedly, legislation at a national level in multiple jurisdictions will be required. It is one thing for the ECB to railroad its inflationary policies through despite protests from politicians in Germany and elsewhere, but begging for equity capital puts the ECB on the back foot. Questions are bound to be raised in political circles about monetary policy failures, and why the TARGET2 imbalances exist. The whole recapitalisation process could descend into an unholy farce, particularly since national central banks may need capital injections as well before they can recapitalise the ECB in proportion to their shareholder keys.
Yet, we rely on the euro system to backstop the entire commercial banking network. How that is to be done is further complicated by most Eurozone nations (if not all of them) having passed bail-in legislation, which means that in a bank failure large depositors and bond holders will be wiped out before deposit protection schemes for smaller depositors are implemented. Nothing could be more designed to accelerate loss of confidence in providers of sources of balance sheet finance who are not small insured depositors, with the potential to spread a widespread collapse across the entire banking network.
Furthermore, there are bound to be Eurozone equivalents of Silicon Valley Bank, whose balance sheets have been undermined to the point of insolvency by the unexpected rise in interest rates and collapse in bond values. There is a repo market facing a receding tide and GSIBs with heavy exposure to derivative counterparty risks. Yet, the euro system itself is bankrupt, having paid top-euros for bonds which have been sinking faster than a tropical sun in the evening. It is in the nature of a banking crisis that several factors come together in an unexpected perfect storm. We will all be wise after the event. But for now, we can only observe the disparate strands likely to come together and destroy the euro system, its commercial banks, and possibly the euro itself.
Eurozone governments face a funding crisis
With a commercial banking system faced with contracting credit and increasing the cost of borrowing, the impact on government funding is sure to be profound. The ECB has already lost control over interest rates, having been forced to raise them against its will and against its economic philosophy. It has had to reduce its holdings of government debt and will find it virtually impossible to reverse its quantitative tightening so long as inflation remains significantly above the 2% target. Furthermore, it is likely that energy prices will start rising again as Europe restocks natural gas ahead of next winter. Oil prices might also rise, because US strategic reserves cannot be used to suppress the price for much longer, and speculators appear to have sold energy short.
Rising interest rates have sprung debt traps on governments throughout the Eurozone. The table below quantifies the current position — the last column showing government debt relative to the GDP of its private sector tax base, showing the true burden of a government on its citizens.
On paper, the situation has improved for all these nations following the covid crisis. At that time, government spending shot up to its highest levels relative to GDP, while GDP also declined materially. Since then, there has been a general recovery in GDP, reducing both government spending as a proportion of it, and debt to GDP ratios. However, having become hooked on the largess of the euro system’s magic money tree, it is now politically impossible for these nations to escape from their debt traps.
Debt traps are being sprung on them by higher funding costs. Advised by their neo-Keynesian economists, there is an expectation that not only will the inflation dragon be slain but interest rates will fall, and funding deficits and novating maturing bonds can continue as before. This will prove to be a costly error.
As noted above, bond yields in some government debt markets have become out of line with where you might expect them to be. With a debt to GDP of 171% and government spending at 52.5% of GDP, it is ridiculous that Greece’s 10-year bond yields only 3.8% — the same as the US Government. At some stage — probably in a wider crisis, the market will refuse to lend funds to the Greek government at anything like this yield, if at all. When arbitrage between the different Eurozone bond markets is suspended, which always happens when risk considerations become the major factor, Greek and some other national debts will simply become impossible to fund. Portugal is another basket case, and in another financial crisis, Ireland will prove to be as well.
And how are these indebted governments and their national central banks going to backstop their part of a failing banking system, comprised of overleveraged commercial banks and a network of central banks mired deeply in negative equity?
Only time will tell.