“Bond Vigilantes” Approve ECB-EBA Stressing Euro Banks (10/28)     Print Email

By J. Paul Horne, Independent International Market Economist

Bond markets reacted very positively to the most comprehensive and rigorous assessment ever of EU and Euro zone banks published on Oct. 26. Barring surprises on European budgetary policies later this week, the report by the European Central Bank (ECB) and European Banking Authority (EBA) on the health of European banks is likely to boost confidence not only of financial markets but that of the overall economy. If the passing grade on Europe’s banking system contributes to improved consumption and capital spending, recent worries about deflation could be attenuated.

The ECB’ Asset Quality Review (AQR) and stress tests covered 150 European Union banks (130 in the 18 Euro zone countries), representing 85% of Europe’s banking system. The reports showed that at end-2013, 25 Euro zone banks (none a major bank, except Italy’s Monte dei Paschi di Siena (MPS), which was long known to be a problem), needed to raise a total of €24.6 billion in new capital, a manageable amount and in line with market expectations.

Even better news, however, was the data through September 2014 which showed that 12 of the 25 banks had raised about €15 billion in core Tier 1 capital this year, enough to meet the minimum capital ratio, leaving only 13 banks which must raise €9.47 billion in new capital.[1]   These banks now have two weeks to inform the ECB, EBA and national regulators how they will boost their capital. If their plans are approved, they will have up to nine months to do so.

Mr. Andrea Montanino, Executive Director of the IMF and incoming Director of the Atlantic Council’s Global Business and Economics Program, assessed the ECB-EBA results as very good news for European banking and the economy. He emphasized the wide-ranging nature of the “Comprehensive Assessment” which included the first Asset Quality Review (AQR) of banks’ assets based on rigorous criteria, harmonized with the 18 Euro zone bank regulators; and a sample of 20% of total bank assets such as mortgages, corporate loans, contingent capital bonds (“CoCos” which convert to equity that can be lost if key capital ratios decline under stress) and other investments. The AQR obliged banks to reduce the value of their assets by a total of €47.5 billion. Another €135.9 billion was identified as non-performing loans, or “troubled assets” on Euro zone banks’ balance sheets, requiring adjustment of their capital ratios.

The stress tests were much more credible, Mr. Montanino said, than those of 2011 and 2010, even though the baseline scenario was based on the European Commission’s economic forecast for 2014-to-2016 that was more optimistic than the IMF’s latest forecast which expects 0.5% less GDP growth in 2015 than does the EC. Under the baseline scenario, the banks had to maintain a minimum capital ratio of at least 8%.

The ECB’s “adverse” scenario, however, was far more drastic, calling for the banks to maintain their capital buffer at 5.5% during three years of recession in 2014-2016 causing the EU’s GDP to shrink a cumulative 7% below present forecasts, and unemployment to rise to a record 13%. Such a draconian scenario, combined with the AQR’s tough valuation of today’s assets, clearly made the results through September 2014 far more credible to markets.

Despite such a severe shock, the Euro banking system was deemed able to emerge with a median core Tier 1 capital ratio of 8.3% by 2016 (compared with a minimum 7% ratio by 2018, the target for all banks reporting to the BIS). The ECB-EBA Euro zone bank results would, Mr. Montanino suggested, compare very favorably with the last stress testing of U.S. banks.

He also pointed out that direct capital injections into Euro zone banks by national governments since the 2011 stress tests, reported by the ECB-EBA, were somewhat surprising. The German government, for instance, injected €144 billion into German banks, equivalent to 5.4% of GDP; whereas France had injected 1.3% of GDP and Italy only 0.4%. Recourse to private capital markets, or pared back balance sheets, had enabled most Euro zone banks to increase their capital ratios.

On the larger impact of the ECB-EBA tests, ECB Vice President Vítor Constâncio was quoted by the “Wall Street Journal”: “By identifying problems and risks, it will help repair balance sheets and make the banks more resilient and robust. This should facilitate more lending in Europe, which will help economic growth.”

Markets Approve

Bond markets clearly approved the ECB-EBA review results. The Euro zone government yield curve, shown in Fig. 1 below, was unchanged at Europe’s close of business on the first trading day (Oct. 27) after the ECB’s announcement, from a week ago and significantly below that of a month ago – a clear sign that the ECB-EBA results are reassuring.

Figure 1 – Euro zone government yield curve


Source: http://markets.ft.com/RESEARCH/Markets/Bonds - As of European close on Oct. 27, 2014.

Over the past month, Euro government 10-year yields had diverged somewhat, indicating that the “bond market vigilantes” had re-awakened after snoozing over the past year when bond yield drifted down to pre-crisis lows. Their complacency was undoubtedly inspired by ECB President Mario Draghi’s mid-2012 pledge to “do whatever it takes” to save the euro. But the truce seemed to be ending as Greece’s bond yield, still the most sensitive indicator of bond market nerves, had risen sharply since early September when it reached its lowest level since mid-2010, as shown below in Fig. 2.

Figure 2 – Greek 10-year government bond yield.


Conversely, the German bund yield, considered the Euro zone’s bond shelter, plunged as investors moved funds from the riskier “peripheral” Euro states into safer bunds, taking the yield down to an all-time low of 72 basis points (bps) early this month, as shown in Fig. 3 below. The bund yield declined one basis point on Oct. 27 to a risible 84 bps.

Figure 3 – German 10-year government bond yield.


Equally reassuring was the performance of the Euro zone’s safest bond, the European Financial Stability Facility (EFSF) AAA-rated bond. Its yield rose two bps to a (miserly) yield of 27 bps, compared with an average 0.23% in September and an all-time high of 2.57% in May 2012.

Figure 4 – European Financial Stability Facility bond yield.


Equity markets reacted somewhat less positively, probably because of continuing concerns about weak economic and corporate profits growth in Europe and slowing economic growth in emerging markets, notably in China and Brazil. Equity investors clearly did not expect the ECB-EBA test results to produce an immediate surge in economic growth and profits. European equity market indices finished down an average 1% on the first day of stock market trading (Oct. 27) but with early losses pared sharply. Fig. 5 illustrates the EuroStoxx50 index for Euro zone blue chips sideward move this year.

Figure 5 – European equity market indices.


Source: http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=XX%3ASX5E&insttype=Index&freq=1&show=&time=19 on 27oct14.

ECB monetary policy and economic implications.

With financial markets apparently relieved by the AQR and stress test results for the European banking system, what are the implications for ECB monetary policy ? Although their passing grade from the ECB and EBA might give a boost to European confidence, European banks are not likely to accelerate lending to the Euro zone economy, to either the consumer or corporate sector. The former is still seriously under-employed and the latter is still over-indebted and must continue to deleverage well into next year.

We are confident, therefore, that the ECB will continue its Long-Term Refinancing Operations (LTRO), as well as its new program for buying Asset-Backed Securities (ABS) which aim to add approximately €1 trillion to the ECB’s balance sheet by end-2015. Reflecting the amount of monetary resources pumped into the Euro zone’s economy, the ECB’s balance sheet has shrunk significantly since peaking at slightly more than €3.1 trillion in early 2012 to a little over €2 trillion on Oct. 17, 2014. (See Fig. 6 below for the ECB’s balance sheet from its inception in 1999 to October 17, 2014.)

Figure 6 – Balance sheet of the ECB.


Source: By courtesy of Cumberland Advisors - http://cumber.com/ on Oct. 27, 2014.

(The U.S. Federal Reserve has been far more aggressive in providing monetary stimulus to the U.S. economy since the 2009-2010 Great Recession. The Fed’s balance sheet totalled $4.3 trillion as of Oct. 22, its all-time high, although the Fed will end its Quantitative Easing program of purchases of Treasury and mortgage-backed securities by November.)

Given that the Euro zone economy is stagnating, or may have already slipped into recession, with the attendant risk that inflation expectations morph into deflation fears, we are certain the ECB will continue its unorthodox monetary policies of LTRO and ABS. “Whatever it takes” to prevent another round of Euro debt crisis could eventually include, we are confident, resumption of ECB purchases of sovereign debt issues on the secondary bond markets, as it did in 2010 and 2011.

Berlin’s negative stance on such quantitative easing by the ECB would, we think, evaporate in the face of renewed pressure from the “bond vigilantes”. They do, after all, determine the borrowing costs of Euro zone governments, and could, if they judge European governments’ efforts at fiscal and structural reform too dilatory, once again force up yields and spreads, thereby threatening the euro. As they have shown in the past, European political leaders will bow to such renewed market pressures and undertake serious reforms to protect the euro.

The ECB becomes the Single Supervisor.

On Nov. 4, the ECB will become the EU’s single banking supervisor, heading the new Single Supervisory Mechanism (SSM) which will monitor the financial stability of banks based in participating states. Euro zone states are obliged to participate, while EU states outside the Euro zone can voluntarily participate. As of August 2014, none of these had opted to join, although the ECB is reported to be negotiating with some to determine how national regulatory legislations could be altered to participate in the SSM. As the first and crucial part of the EU’s planned banking union, the SSM will work with the EU’s Single Resolution Mechanism which also remains a work in progress.

(For details and prospects of the SSM and EU banking union, see James David Spellman’s comprehensive report in European Affairs.

The Next Challenge may be Fiscal

With the ECB-EBA reasonably positive comprehensive assessment and market reaction behind us, the next challenge for the Euro zone could come soon, perhaps on Oct. 29 when the European Commission is expected to issue letters to Euro zone governments on their 2015 budget plans. The EC is expected to encourage the peripheral Euro states who, by dint of painful belt-tightening, are in better shape than could have been imagined when the Euro debt crisis erupted in late 2009.

Of most concern, however, are two EU heavy weights: Italy and France who presented 2015 budgets with projected deficits over-shoot the EC’s 3%-of-nominal-GDP target for next year. Matteo Renzi, Italy’s dynamic young reforming PM, has indicated that he is willing to work with the EC to achieve a smaller structural deficit (ex-interest on the national debt). Rome is expected to revise its budget plan to comply with the EC’s target over the next few weeks.

Manuel Valls, France’s equally ambitious Socialist PM, is also pushing tough structural reforms in France. But with the left wing of the PS resisting some key reforms, and the rightwing National Front party gaining support for its populist anti-EU and anti-euro platform, Paris is asking the EC for more leeway for its 2015 budget. Under pressure from Berlin, however, the EC may demand a greater belt-tightening effort from the French government, particularly in trying to reduce public sector spending which today accounts for over 57% of GDP, one of the highest ratios in the EU. If Paris resists, there could be an adverse market reaction later this week.

One must hope that “Vallenzi”, as “The Economist” dubbed the two youthful PMs, will succeed in pushing through structural reforms of labor, commercial and product markets to enhance national productivity growth in France and Italy which would help reduce their deficits to manageable levels.


J. Paul Horne is an Independent International Market Economist based in Alexandria, VA and Paris where he was chief international economist for Smith Barney for 24 years. He retired as a Managing Director of Salomon Smith Barney/Citigroup in 2001 but remains active with the National Association for Business Economics, the Global Interdependence Center and the Société d’Economie Politique in Paris.


[1]The core Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by the Regulator (in this case, the ECB). Most central banks follow the Basel Committee on Banking Supervision (BCBS – part of the BIS) guidelines in setting formulae for asset risk weights. Assets like cash and currency usually have zero risk weight, while certain loans are risk-weighted at 100% of their face value. Under BCBS guidelines, total RWA includes Credit Risk, Market Risk (typically based on value at risk (VAR) ) and Operational Risk. BCBS rules for calculating total RWA have been updated several times since the financial crisis of 2007–09. Source: http://en.wikipedia.org/wiki/Tier_1_capital >