The BIS (Bank for International Settlements) Quarterly Report, published March 12, 2012, shows how Mario Draghi's grand plan to restore confidence in European banks is working. If you are a Financial Times reader, this is going to surprise you because the FT writer got the message backwards in her lead paragraph:
Calls by European regulators for banks to hold more capital exacerbated concerns over the health of the eurozone's financial sector and led to fears of a squeeze in lending to businesses and households, the Bank for International Settlements said on Sunday.
The Draghi Plan, as I have been saying, is:
- to liquefy the banks to permit them to do two things: increase their capital and buy or finance the purchase of sovereign debt;
- to back the European Banking Authority's requirement that banks accelerate their capital-boosting plans to comply with Basel III standards by June 2012 in order to make the banks capable of funding themselves for the longer term; and
- to make the banks' financing of their sovereigns less risky by enforcing fiscal standards across the Eurozone and encouraging restructuring of capital and labor markets.
The BIS Quarterly Report shows that steps 1 and 2 are working as planned at this early stage. The writers of the report described fears about the possible impact of the capital-raising plan, but found that the fears had been unfounded because the capital markets had stepped in to replace lost bank lending:
At their peak, bank funding strains exacerbated fears of forced asset sales, credit cuts and weaker economic activity. New regulatory requirements for major European banks to raise their capital ratios by mid-2012 added to these fears. European banks did sell certain assets and cut some types of lending, notably those denominated in dollars and those attracting higher risk weights, in late 2011 and early 2012. However, there was little evidence that actual or prospective sales lowered asset prices, and overall financing volumes held up for most types of credit. This was largely because other banks, asset managers and bond market investors took over the business of European banks, thus reducing the impact on economic activity.
Data show that banks with identified capital shortfalls (EBA) reduced lending in 4th Q more than others. Increased financing from other banks and bond market investors largely compensated for the cuts made by European banks in the final quarter of 2011. As a result, the overall volume of new syndicated and large bilateral loans was essentially the same as in the third quarter.
The process of European banks doing less of the Continent's lending, with businesses relying more on the capital markets, as they do in the United States, will permit the European banks to be stronger and to rely less on the capital markets to fund them.
The BIS report continued:
The extent of asset-shedding observed in markets reflects a broader trend among European banks towards deleveraging over the medium term. French and Spanish banks, for instance, sold dollar-funded assets and divested foreign operations partly to focus their business models on core activities.
The European banks also spelled out their plans to raise capital as required by the European banking Authority:
Planned capital measures thus account for 77% of the overall effort, and comprise new capital and reserves (26%), conversion of hybrids and issuance of convertible bonds (28%), and retained earnings (16%), while the remaining 23% rely on RWA reductions, notably on internal model changes pre-agreed with regulators (9%) and on the shedding of assets (10%), comprising planned RWA cuts of €39 billion in loan portfolios and some €73 billion through asset sales.
This means that the banks are not, on the whole, proposing to dilute their shareholders greatly at a time when their stock prices are low relative to their book values. The banks will, instead, use a variety of measures, including some deleveraging, to accomplish their required capital goals.
These efforts already are making the banks readier to fund their cash needs themselves. They were still reliant on the ECB for LTRO funding:
Euro area banks raised large amounts of funding via the ECB's three-year LTROs, covering much of their potential funding needs from maturing bonds over the next few years. Across both operations, they bid for slightly more than €1 trillion. This was equivalent to around 80% of their 2012-14 debt redemption, more than covering their uncollateralised.
Some commentators have suggested that LTRO has not satisfied the banks' funding needs. I believe the BIS figures show that the significant question is the banks' unsecured funding needs, and that these have been satisfied.
The even better news is that the capital markets for unsecured funding are beginning to open again for many European banks:
Bank funding conditions improved following these central bank measures. Investors returned to long-term bank debt markets, buying more uncollateralised bonds in January and February 2012 than in the previous five months. US money market funds also increased their exposure to some euro area banks in January.
This shows that with better capital levels, the European banks will be able to be weaned off central bank funding. As the BIS authors said, "Banks are mindful that a sustained increase in their capitalisation would facilitate both regulatory compliance and future access to the senior unsecured debt market."
The BIS report also shows that Italian and Spanish banks, at least, did use a part of their LTRO money to support their sovereign debt markets. The Italian banks bought about €15 billion and the Spanish banks about €45 billion. These figures may be in addition to the banks' financing of their customers' purchases.
Part 3 of the Draghi Plan, making sovereigns such as Italy and Spain capable of standing on their own, is likely to be the most difficult part to accomplish. And there is no getting away from the fact that using the banks as a vehicle to relieve some of the sovereign debt market stress will have made the banks more brittle. These actions also will have made the ECB itself and other central banks vulnerable because of the collateral they hold and their obligations to each other, such as under the European monetary clearing system.
The bottom line is, increasingly, that European institutions, including German institutions, are so mutually intertwined that closer cooperation is likely to become inevitable. Whether one likes it or not, the United States of Europe looks more and more likely.
The immediate impact of these forces on investors is, in my view, that investment in major European banks is now sensible, and I intend to put some money there. Perhaps I was needlessly cautious about a year and a half ago when I basically withdrew from the European market, but I did not then see a way forward. It is only since Draghi's ECB presidency began November 1st that I have begun to see how European banks could get out of the box into which low capital-and hence inability to fund themselves-had put them. The Draghi Plan still may fail. But I do not think it is going to fail in the next year, at least, and during that time, I think there is a nice opportunity for some major European banks to trade at much closer to their book values.
It would be ideal to effect this investment through a targeted ETF that owned almost exclusively Continental bank stocks. Unfortunately, I cannot find such a vehicle. The STOXX Europe 600 Banks (BNKP) is the closest thing. But it is about one-third UK banks. iShares MSCI Europe Financials (NASDAQ:EUFN) also is not a very pure play because it has insurance company exposure as well as UK exposure.
For myself, therefore, I am falling back on creating a small basket of individual stocks, and I have elected to begin with two French banks-Credit Agricole (OTCPK:CRARY) and Societe Generale (OTCPK:SCGLY)-and one German bank--Deutsche Bank (NYSE:DB). I am still leery about Italian and Spanish banks because of their local sovereign debt exposures.
Deutsche Bank's U.S. volume is sufficient that one need not worry about its liquidity. Societe Generale's U.S. ADR volume is adequate unless one makes a substantial investment. Credit Agricole's U.S. volume is small, however, and an investment of even $20,000 would be too high for comfort on the liquidity side. Therefore, if one considers an investment in Credit Agricole, one should consider whether it might be better to trade it in Paris (ACA.PA) despite the higher commission for most Americans (in my case, $100 for the Paris trade, as opposed to less than $9 for the U.S. trade). These three stocks are off their lows, but I feel more comfortable with the data that has been reported over the last couple of weeks. Perhaps I am a little late to the party. But buying at the absolute low point is not always the most important thing.
Vigilance will remain necessary regarding this investment because the picture in Europe can change quickly. But you knew that.