The end of European banking
The €1 trillion in ultracheap three-year loans the ECB doled out in December and February was supposed to have stabilized the entire European banking system. It appears to be having the opposite effect.
European banks — especially those that rely on ECB LTRO financing — are bracing themselves for an imminent downgrade, according to an article in yesterday’s Wall Street Journal:
While Moody’s hasn’t said whether and to what degree it will cut various banks’ ratings, officials at multiple top European banks said they expect their grades to be knocked down at least one notch…
As part of its downgrade reviews, Moody’s is examining the degree to which banks are reliant on the ECB loans and “what are the banks’ abilities to wean themselves off that funding,” said a person familiar with the matter. Heavy borrowing from the ECB “prompts more intense scrutiny” from Moody’s about the banks’ financial health, this person said.
When Moody’s finally cuts these banks’ ratings, it will be costly: Royal Bank of Scotland estimated in a recent filing that a one-notch downgrade would force the bank to post an additional £12.5 billion of collateral.
It’s not clear how much longer European banks can last in their current form, according to a recent Barclays research note. More radical solutions to banks’ woes may be needed, Barclays analysts Simon Samuels, Mike Harrison, and Nimish Rajkotia wrote:
European banks are now unique in their inability to fund… With sovereign debt issuance crowding out bank debt, we think it highly unlikely that the funding model that worked pre-crisis can be re-established.
The trio outlines a number of alternative funding models, from the politically problematic (“the ECB will simply have to fund the balance sheets of European banks for many years to come”) to the fanciful (“another potential solution… would be the creation of a European Freddie/Fannie”). The alternative that has the greatest chance of coming to pass seems to be a “meaningful deepening of the corporate bond market” and a shift away from large-scale corporate lending for European banks. There’s a lot of scope for the European corporate bond market to expand — only 10-15 percent of European corporate financing comes from the bond market vs. 50-70 percent for the U.S.
In fact, European corporations are starting to plan for a landscape where bank lending is no longer the dominant source of funding. According to JP Morgan, after falling by €32 billion in December, bank loans to nonfinancial corporates in the eurozone were effectively zero in the first two months of 2012:
Moreover, the first quarter of 2012 marked only the second quarter in recent years in which corporations borrowed more from capital markets than they did from banks:
Companies ranging from Dutch chemical maker LyondellBasell Industrials NV to German auto-parts maker Schaeffler AG borrowed $179.5 billion by selling bonds in the first quarter, a 38% year-to-year jump, according to Dealogic. By contrast, the amount borrowed from banks fell 45% to $112.9 billion.
Of course, in addition the dire straits of its banks, Europe is also undergoing a sovereign debt crisis. European sovereigns face much weaker demand for their debt than corporations, and there are signs that increased corporate bond issuance could crowd out sovereign debt purchases:
[B]ond-market investors increasingly are avoiding government bonds of fiscally weaker European countries, and instead seeking to park their money with relatively healthy companies, whose bonds can offer similar yields.