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Samantha Azzarello
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Samantha Azzarello has served as an Economist at CME Group since 2012. In this role, she is responsible for conducting macroeconomic research and analyzing domestic and global economic developments that impact the company’s business. Azzarello has conducted analysis on the relationship between... More
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  • Watching European Bank Reform

    For the Euro-zone, the worst of the damage from the sovereign debt and banking crisis appears now to be in the past, but conditions certainly do not warrant a party either. The stagnant growth environment in the Euro-zone is still reflected in GDP numbers, with 2013 estimated year-over-year GDP growth of -0.4%, showing only a modest improvement from the -1% posted in 2012. Forecasted growth for 2014 of 1% provides a hint of optimism. Deflation is still a concern, and the weaker economies of the Mediterranean countries, while having made progress-observe Italy achieving an operating balance in its budget and Spain growing exports and producing meaningful pension reform-still need to be watched closely.

    (click to enlarge)

    From our perspective, the most significant challenge hampering strong Euro-zone economic growth is the completion of a centralized authority supervising the banking system, or so-called banking union. So far, European regulators have been focusing on how to deal with a failing bank-essentially a needed, yet backward-looking exercise. For the Euro-zone to return to healthy growth, the credit system needs to play a strongly supporting role. And EU policymakers have yet to proactively formulate impactful reforms that might encourage and foster the Euro-zone bank lending needed to support growth.

    The handling of EU-wide banking reform thus far has been burdened by the usual suspects: political confusion and indecisiveness, disagreement among finance ministers lobbying for their country's interests, and inadequate sources of funding. While a centralized supervisor of the banking system would be able to handle a failing bank in a swift, fair and decisive manner with the least amount of disruption to markets as manageable, that is not a sufficient condition to get the Euro-zone economies moving again. We argue that, more importantly, until a centralized supervisor is able to create reforms which encourage banks to lend, economic activity will be hindered. Overall, we are monitoring any signs of whether the regulation and supervision of Euro-zone banks are moving from being defensive and worrying about how to share the burden of a failing bank to being proactive about growing lending and improving credit conditions; and we have yet to see encouraging signs.

    Banks and Sovereigns: You get one, you get that other one

    There exist two cyclical effects which lace the sovereigns and their national banks together. This strong interdependence or so-called "doom-loop" between the banks and their corresponding sovereign state has effectively defined every flare-up of the Euro-crisis. Moreover, these two distinct effects characterizing the Euro-zone banking system are highly differentiated issues from the challenges faced in the US.

    First, in the absence of a supranational bank regulator and supervisor, member states have kept individual responsibility for and oversight of their national banking systems. That responsibility is far from trivial. The banking system in the Euro-zone is very large relative to the size of the economy. To illustrate, note in the US total assets on the balance sheets of US banks are $14.6 trillion, which is about the same size as the US economy, with a nominal GDP of $16.7 trillion. Compare that almost 1:1 ratio to the Euro-zone, where total assets of Euro-zone banks are €30 trillion, which is significantly greater than the €9.5 trillion ($12.9 trillion at an exchange rate of 1.37 USD/€ ) composing total Euro-zone GDP, demonstrating that the size of Europe's banking sector is almost three times greater than the size of its economy. This large ratio of bank balance sheet size to nominal GDP reflects the relative importance of banks in the Euro-zone credit system relative to non-bank lending and public debt market bond issuance; that is, the lack of depth, liquidity, and breadth of access in corporate bond markets in the Euro-zone as compared to the US.

    A second factor tying the banks with the sovereigns in an unhealthy embrace lies in the assets the banks hold. Large proportions of domestic government debt are held on the balance sheets of many European banks. So, any shadow of a doubt on the solvency of the government falls directly onto that country's banks. In contrast, US banks are not large holders of government debt. The reserve currency status of the US allows it to fund its debt with an emphasis on the desire and willingness of international central banks to acquire large stockpiles of US Treasury securities. Euro-zone nations do not have this source of international demand, and they have relied heavily on their own banks to buy and hold their sovereign debt.

    High-Yield Debt Issuance Moves onto Bank Turf

    Given the Euro-zone banks' dual, key roles to provide credit for both commerce and their governments, getting their banking system back to good health has been incredibly difficult. As tighter regulation and supervision has forced Euro-zone banks to shore up capital, decrease balance sheet size, and enhance the quality of their capital, they have effectively been removed from supporting economic growth. This has led to an interesting side effect. A decrease in lending by Euro-zone banks has forced corporations of many types to seek funding elsewhere. This alternate source has been through the public debt markets, and for smaller to medium size firms this means the high-yield bond market. With banks losing their grip on certain customer segments, corporate high-yield debt issuance soared 127% from 2011 to 2013. By contrast, US high-yield debt grew by only 21% during that same time period. Effectively, the supply of high-yield bonds has been growing from corporations that have been marginalized from getting loans from Euro-zone banks due to a decrease in lending, while on the demand side, high-yield European debt has been sought after by investors and money managers in a "search for yield" over the past 5 years of low interest rates.

    (click to enlarge)

    This shift from corporate loans from banks to public market debt issuance underscores a decreased source of business and revenues for Euro-zone banks on the one hand, and on the other represents hope for future economic growth. To the extent that public debt markets and non-bank sources of finance can provide more of the credit needed to grow European exports and take some of the burden from the banking system, Euro-zone economic growth is less dependent on the pace of forward-looking reforms in the banking system, which are likely to be very slow to arrive even if some progress can be seen.

    Moving (slowly) towards a Banking Union

    Currently, there exists a hybrid of the originally proposed supranational, all powerful banking union overseeing the entire Euro-zone banking system and a network of national supervisors. The European Central Bank (ECB) will supervise (and be able to give direct bail-outs) to the three largest banks in each country as well as any bank holding assets in excess of €30 billion or having significant cross-border activities. This equates to the ECB supervising approximately 130 banks. The remaining 6,000 or so banks in the Euro-zone will be monitored by their own national supervisor.

    An added consideration is 2014 being the year of another round of stress testing for the Euro-zone banks, also known as Asset Quality Review (AQR). Given the lack of credibility in previous bank stress testing in Europe, this round of ECB-conducted tests puts the central banks credibility at risk if they are not perceived as being tough enough. Arguably, the last thing the ECB wants is to provide ammunition for a new round of crisis, yet they cannot afford to go easy on undercapitalized banks. This conundrum for the ECB suggests further delays before banking policy turns more proactive. And just to underscore the timeline for policy reform, the creation of a Resolution Fund which will be fully funded to €55 billion by 2026 is unlikely to suffice in assuring market participants, or anyone for that matter, that sufficient capital exists to assist weak banks in the interim.

    We return to our base case argument that for Europe to grow at a healthy pace, its financial system needs more capital and reforms that will actually encourage bank lending. While the process of Euro-zone banking reform is underway, it remains focused on how to deal with failing banks, has not yet shifted to a proactive approach to help encourage the lending needed to grow small- and medium-size businesses as well as exports, and has proceeded painfully slowly. On the more positive side, financial intermediaries have moved into some of the banking system's turf to offer public debt market alternatives for lending to corporations. This offers the possibility of credit growth even while the banking system is still healing. On net, it is difficult to become optimistic about Euro-zone economic growth when, five years after the initial financial crisis, European regulators are still largely focused on solving backward-looking problems. Economies thrive on a healthy and well-capitalized financial system capable of supporting commerce, and there is still a ways to go in the Euro-zone to get back on track.

    All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

    Jan 30 2:33 PM | Link | Comment!
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