Basel Rules And The LTROs: An Accidentally Toxic Mix

| About: iShares MSCI (EUFN)

In an article published on August 20, I noted that European banks were sitting on around 1.5 trillion euros in non-performing loans. This assertion was based on a note from accountants KPMG, who contend that the ECB's LTROs are preventing eurozone banks from deleveraging by

"...strengthen[ing] banks' balance sheets in the short to medium term, allowing some to delay asset sales and prolong restructuring negotiations."

An article published Tuesday by Bloomberg entitled "Europe Banks Fail to Cut as Draghi Loans Defer Leverage" confirms this analysis. In the article, Bloomberg notes that since promising to cut over 900 billion euros in assets last year, European banks have done exactly the opposite, instead increasing assets by 2.8 trillion euros. As the title of the piece suggests, Bloomberg explicitly blames the ECB for the delayed deleveraging:

"The ECB president's decision nine months ago to provide more than 1 trillion euros of three-year loans to banks eased the pressure to sell assets at depressed prices."

The original idea behind the selling of assets was of course to boost capital. The LTRO loans assisted in the capital raising process, but in a dangerous way. Recall that one of the implicit aims of the LTROs was to encourage banks to execute carry trades with distressed sovereign debt. This was supposed to be a win-win for periphery governments facing funding pressure and banks seeking to raise capital, the idea being that the money borrowed from the ECB at 1% would be used to purchase sovereign debt yielding at least 3 times that, providing relief for both the banks (in terms of capital) and periphery governments (in terms of borrowing costs). The banks took advantage of the cheap ECB funding to purchase around 500 billion euros in sovereign debt according to a JPMorgan analyst cited by Bloomberg.

The problem here is that government bonds are considered "rosk-free" under Basel rules and as such, banks don't have to hold any capital against them. This means that,

" assets for ones considered less risky, lenders can reduce their risk-weighted assets, even as total assets increase. Some also have changed their mix of assets to reduce the amount of capital they need to hold." (emphasis mine)

So banks are rewarded for holding sovereign debt in two ways. They don't have to hold any capital against it, and they get a yield that is greater than the interest rate on the money they borrowed to buy it with. But as we know, the yield is high for a reason -- that risk free sovereign debt isn't risk-free at all. In fact, it is the exact opposite. Indeed the Cyrpus case is a stark reminder of what can happen to a country's banking sector when a disproportionate amount of sovereign debt gets written down.

Ultimately, the LTROs have encouraged banks to gorge themselves on risky sovereign debt against which they are required to hold no capital, effectively ensuring that two things are the case: 1) banks' assets are greater, and 2) banks' capital is less as a percentage of those assets than it should be given the disproportionate amount of risk free sovereign debt on the books.

Note that this is the very opposite of what should be happening. That is, banks should be deleveraging and disposing of assets while raising capital. Instead, they are buying more assets, and these assets are the worst kind of oxymoron: they are extraordinarily risky yet they carry a zero risk weighting. Thus banks' assets are increasing yet their risk-weighted assets are decreasing, a trend one analyst cited by Bloomberg calls "intriguing."

Intriguing indeed. One can see how this has the potential to create rather large problems. If this mountain of sovereign debt should have to be written down (as Greek debt was in Cyprus), banks will have been required to put aside zero capital against it, ensuring that the resulting shortfall will be far larger than it otherwise would have been if the sour debt didn't carry a zero risk weighting in the first place. The implications here are rather straightforward. If it becomes apparent over the course of the next six to twelve months that a PSI is in the works for either Spain or Italy, the enterprising investor will seek out the banks which have the most exposure to those two countries and place bets against them. Alternatively, one might simply place bets against the iShares MSCI European Financial Sector ETF (NASDAQ:EUFN).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.