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ECB Financial Stability Review June 2009: Eurozone banks face $283bn writedowns

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Eurozone banks face additional losses of more than $283bn this year and next as continental Europe’s severe recession intensifies strains on its financial sector, the European Central Bank has warned.

The fates of the eurozone economy and its banks have become increasingly interlinked, the ECB reported on Monday in its latest “financial stability review” with banks losses expected to be focused on their loan exposures. Risks to the stability of the financial sector remained high, it said, while “uncertainty prevails” over the shock-absorbing capacity of the banking system.

ECB Press release

15 June 2009 - Financial Stability Review June 2009

Many of the downside risks to euro area financial stability that were identified in the December 2008 issue of the FSR have crystallised [1]. In particular, the further significant deterioration of global macroeconomic conditions, as well as sizeable downward revisions to growth forecasts and expectations, have added to the stresses on global and euro area financial systems. The contraction of economic activity and the diminished growth prospects have resulted in a further erosion of the market values of a broad range of assets.

Large and complex banking groups (LCBGs) in the euro area have been responding to the challenging macro-financial environment by making efforts to de-leverage and de-risk their balance sheets, although this has been hindered by the illiquid and stressed conditions that have characterised many financial markets. The adjustment of bank balance sheets has entailed adverse feedback on the market pricing of assets and on banks’ financial intermediation role of channelling funds from savers to investors. Moreover, increasing signs of an adverse feedback loop between the real economy and the financial sector have posed new challenges for the safeguarding of financial stability.

Because of the continued stresses and impaired liquidity of many financial markets, a range of remedial policy measures have been taken both by central banks and by governments, with the aim of preventing this adverse feedback and fostering the flow of credit. The significant narrowing of money market spreads over the past few months indicates that the central bank measures have contributed to improving the functioning of money markets. At the same time, hard-to-value assets have remained on bank balance sheets and the marked deterioration in the economic outlook has created concerns about the potential for sizeable loan losses. Reflecting this, uncertainty prevails about the shock-absorption capacity of the euro area banking system.

Looking forward, there is a concern that many of the risks identified in this issue of the FSR could materialise if the global economic downturn proves to be deeper and more prolonged than currently expected. In particular, the main risks identified within the euro area financial system include the possibility of:

  • a further erosion of capital bases and the risk of a renewed loss of confidence in the financial condition of LCBGs;
  • significant balance sheet strains emerging among insurers; and
  • more widespread asset price declines coupled with high volatility.

Outside the euro area financial system, important risks include the possibility of:

  • US house prices falling further than currently expected;
  • the economic downturn in the euro area being even more severe than currently projected; and
  • an intensification of the stresses already endured by central and eastern European countries.

All in all, and notwithstanding the measures that have been taken by the Eurosystem and governments in the euro area to stabilise the euro area financial system and the recent recovery of the equity prices of most LCBGs, policy-makers and market participants will have to be especially alert in the period ahead. There is no room for complacency because the risks for financial stability remain high, especially since the credit cycle has not yet reached a trough. Banks will, therefore, need to be especially careful in ensuring that they have adequate capital and liquidity buffers to cushion the risks that lie ahead, while providing an adequate flow of credit to the economy. Over the medium to longer term, banks should undertake the appropriate restructuring to strengthen their financial soundness and resilience to shocks. This may well include adapting their business models to the challenging operating environment. At the same time, banks should be alert in ensuring that risks are priced appropriately, but not excessively or prohibitively so. The commitments made by euro area governments to support the financial sector have been sizeable across a range of measures. Given the risks and challenges that lie ahead, banks should be encouraged to take full advantage of these commitments in order to improve and diversify their medium-term funding, enhance their shock-absorption capacities and protect sound business lines from the contagion risks connected with troubled assets.

The June 2009 Financial Stability Review, Chapter 4 The Euro Area Banking Sector

Euro area banks came under intense financial stress in the last quarter of 2008, and many large and complex banking groups (LCBGs) suffered substantial losses. While these losses were partly due to further write-downs on their structured product portfolios, the deterioration of the macroeconomic environment in the first quarter of 2009 had a more marked impact, triggering an increase in loan losses and a decline in non-interest revenue. Market participants also became increasingly attentive to the level of capital ratios, which held up well, thanks partly to government recapitalisations and especially to the quality and composition of
capital. The overall outlook for LCBGs remains uncertain, with the prospective increase in loan losses affecting most of these institutions and funding costs remaining elevated beyond very short-term maturities. In this regard, and notwithstanding some improvement in financial positions in the first quarter of 2009, euro area LCBGs will have to take further steps to convince financial markets and authorities that they will be in a position to withstand the risks that lie ahead. More elaborate pricing of loans and hedging of securities, as well as further cost-cutting and rethinking of business models, might be necessary to restore stable earnings and organic capital growth.

Write-downs on structured products continued, and the deterioration of the macroeconomic environment triggered a rise in loan loss provisions. In the fourth quarter alone, write-downs on structured assets at euro area LCBGs amounted to €29.7 billion, the highest quarterly figure so far. For 2008 as a whole, the amount was €70.6 billion.

In the first quarter of 2009, the performance of euro area LCBGs improved somewhat in comparison with that in 2008 as a whole, although there were a few significant underperformers that pulled down the average performance ratios.

According to estimates as at 28 May 2008, the total reduction in net income attributable to write-downs by global banks since the turmoil erupted has amounted to USD 1,042 billion. US, Canadian and Australian banks reported the bulk of the income losses – about 56% of the overall fi gure. A further 20% was suffered by UK, Swiss and other non-euro area European banks, and another 20% by euro area banks. For euro area LCBGs, write-downs amounted to USD 20 billion in the first quarter of 2009. For 2008 as a whole, write-downs for euro area LCBGs amounted to USD 105 billion. There is little evidence, therefore, to suggest that the pace of write-downs has abated.

Bank Capital

Investors and regulators are increasingly focusing on high-quality capital such as core Tier 1 capital – which has the highest loss-absorbing characteristics – and on leverage ratios, instead of on the conventional Tier 1 capital ratios. Further simulations show that, on the basis of leverage ratios such as core Tier 1 to tangible assets (CT1), the capital shortfall is substantially higher. The euro area banks would have to raise €240 billion in core Tier 1 capital to achieve a CT1 ratio of 4%, or would have to deleverage by €6 trillion, equivalent to a reduction of €1.3 trillion in risk-weighted assets. For the European banks, the capital shortfall would
increase to €414 billion or require €10.3 trillion of (tangible) asset shedding, equivalent to a riskweighted asset reduction of €2.3 trillion.

However, it should be stressed that a CT1 threshold of 4% or 5%, which market participants take as a norm, is inferred from US bank averages and is likely as such to be an unrealistic target for euro area banks owing to differences in the definition of assets under different accounting standards. Indeed, euro area banks follow the International Financial Reporting Standards (IFRSs), while US banks report under US Generally Accepted Accounting Principles (GAAP). The IFRSs are extremely restrictive as regards netting of derivatives on the balance sheet, while under US GAAP (or Swiss GAAP, which is similar), netting is much more widely permitted. This has as the effect that assets reported under the IFRSs may in some extreme cases appear almost twice as high as what they would be if reported under US GAAP.

Against this background, European banks are strengthening their capital bases in part by repaying junior bonds which are currently trading at large discounts to face value, mainly owing to concerns about the financial strength and viability of many institutions. The discounts can be booked as profits, which boosts core equity capital. However, repaying liabilities at discounts in combination with asset-shedding can only be one element of the efforts to strengthen banks’ financial soundness in the short term and cannot be a substitute for capital that is generated from retained earnings.

Estimating Potential Write-Downs Confronting The Euro Area Banking Sector As A Result Of The Financial Market Turmoil

As the global financial turmoil has unfolded, several estimates have been made, both by public and private sector institutions, of the potential losses to be absorbed by financial systems. In order to assess the magnitude of probable losses the euro area banking sector faces, this section presents an estimate of total potential write-downs until the end of 2010. Combining these estimates with what is already known about banks’ write-downs on credit-linked securities and losses on loans since the eruption of the market turmoil in August 2007, an estimate of total (past and expected) write-downs is also made.

The first step in estimating potential losses is to gauge the size of exposures of euro area banks to various types of securities where losses could be faced. This was done following a bottomup, bank-by-bank, approach. In particular, individual bank financial reports were investigated to assess the nature and scale of exposures of euro area banks to US-originated securities. Loan exposures of euro area banks, as well as write-offs on these loans in 2007 and 2008, were taken from the ECB’s MFI statistics and data on loan loss provisions were extracted from the ECB’s consolidated banking data.

 

Estimated potential write-downs for the euro area banking sector    
(USD billions)      
    Euro area banks securities
  Outstanding  Cumulative implied write-downs
US-originated securities      
Sub-prime/Alt-A securities  106   59
Prime mortgages backed securities (MBSs)  94   2
Total     61
       
European-originated securities      
Residential mortgage-backed securtities (RMBSs)  397   60
Collateralised debt obligations (CDOs) – non-sub-prime  158   32
Commercial mortgage-backed securities (CMBSs)  68   19
Consumer asset-backed securities (ABSs)  69   5
Other ABSs  15   1
Collateralised loan obligations (CLOs)  40   11
Corporate debt  553   29
  1,500   157
Total for securities      218
       
Sector    Euro area bank loan exposures
  Outstanding  Realised and expected losses
Households 6,520   200
o/w mortgages  4649   44
o/w consumer  847   62
o/w other  1,024   95
Corporates  6,489   230
Total for loans  13,009   431
       
Total for loans and securities     649
Bloomberg estimate of write-downs as of 28 May 2009      215
Loan loss provisions and write-offs in 2007-08      150
Potential further losses      283
Sources: Individual banks’ disclosures, European Securitisation Forum, IMF, ECB and ECB calculations.
Note: Euro values were converted to US dollar figures using the average exchange rate in the period from March to May 2009 (EUR 1 = USD 1.33.
       

 

Glossary

Large and complex banking group (LCBG): A banking group whose size and nature of business is such that its failure or inability to operate would most likely have adverse implications for financial intermediation, the smooth functioning of financial markets or of other financial institutions operating within the financial system.

Sources used: ECB Financial Stability Review June 2009, Financial Times

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