ECB Emergency Lending Shows Crisis Not Over

By Simon Nixon

The news that emergency lending by the European Central Bank skyrocketed this week to its highest level in 19 months is an alarming reminder that the euro crisis is far from over. In my Agenda column in the European edition of the WSJ this week I cautioned that amid all the optimism at the prospects of a European “Grand Bargain”, there will be no end to the crisis unless E.U. leasers find a way to restore confidence in the banking system too. That means action on both bank solvency and liquidity.

The issue of bank funding is critical. As bank funding costs rise, they will either push up the price of credit or refuse to lend. Either way, the result will inflict damage on the underlying economy, putting further pressure on the sovereign. European banks need to refinance €1.7 trillion of bank debt over the next three years. These funding pressures are already pushing up the cost of debt alarmingly in some European countries: Spanish banks are paying up to one percentage point more for five-year debt than they did three months ago. Covered bond issuance has gone through the roof in Europe this year, but the costs of these supposedly ultra-safe securities has risen and the average issue size has shrunk, bankers say.

Meanwhile, some countries’ banks remain shut out of funding markets altogether. The European Central Bank’s balance sheet now funds the equivalent of 18% of Greece’s banking sector assets, 15% of Ireland’s and 7% of Portugal’s. Alarmingly, the Central Bank of Ireland is providing the Irish banking system with a further funding under its Emergency Liquidity Assistance facility, which provides funding to banks that lack collateral eligible for ECB operations.

This is not a position any central bank wants to find itself in. But so long as banks are shut out of markets and can post collateral, there is little the ECB can do about “addicted” banks; if they tried to cut off their funding, the banks would be forced to deleverage quickly, possibly by shedding assets, which would crystallize the very losses that European policy makers are trying to avoid.

Some analysts are increasingly confident that Europe is now beginning to act to shore up capital at the  banks – they have raised €7.5 billion of equity in the first six weeks of the year, according to Morgan Stanley estimates – and that this will help address the funding issue. I’m not so sure – both that there is a concerted effort to recapitalize or that it will solve the problem.

Danske Bank, for example, is raising equity to repay subordinated bonds held by the Danish government. Banco Populare, an Italian lender, is raising capital to absorb losses from its problem leasing business.

True, the Bank of Spain’s demand that Spanish lenders boost their core Tier 1 capital ratios to a minimum 8% is encouraging, but it’s unlikely to be nearly enough to unlock the credit markets for Spanish banks given concerns over likely losses from its real estate market. The Bank of Spain estimates the banks need to raise a total of €20 billion of new capital; yet market estimates put the total equity that may be required to address Spanish banking system solvency concerns as high as €100 billion. Banks in other countries with stressed financial systems, including the U.K., Switzerland, Greece and the Nordic region, have targeted double digit core Tier 1 ratios.

Meanwhile there is no evidence of any drive to increase bank capital in core European countries. The next round of stress tests looks likely to be only a modest improvement on last year’s exercise. At the same time, there is growing concern how some of Europe’s banks will meet the new Basel 3 capital rules. Of the 30 largest banks in Europe, 14 have returns on equity below 5%, according to Morgan Stanley, raising doubts as to their ability to generate sufficient capital organically. Far from easing this year, bank funding problems could yet spread to core European countries in 2011.

Meanwhile National Bank of Greece and Piraeus Bank, for example, have both recently recapitalized but still remain shut out of term funding markets. That’s because investors don’t believe the Greek government is solvent and have no idea how the burden of a likely default might be shared. The same is largely true for Ireland. Any solution to the euro crisis needs to address both sovereign and bank solvency and liquidity issues, including identifying who will bear the costs of recapitalizations: government bond investors, bank debt investors and shareholders. Until we get an answer, the volatility will continue.