Is Dexia the canary in the coalmine?

The news that the Franco-Belgian bank, Dexia, is in financial trouble appears to have concentrated the minds of the Eurozone politicians who are fast forwarding a plan to recapitalise the banking sector.

Public pronouncements by leading European politicians, including Chancellor Merkel of Germany and the President of the European Commission, Jose Barroso, have led to a surge in optimism in markets that a credible plan will be announced soon.

This comes only a few months after the European Banking Authority (EBA) conducted its own stress tests on the banking sector which gave it a clean bill of health with a few minor exceptions (incidentally, Dexia was rated the 12th strongest bank out of the 90 tested by the EBA).

The volte face reflects the belated realisation that the tests, as were the ones in 2010, were a whitewash that overlooked and underestimated the current financial stress in the Eurozone that has recently spread to the banking sector from the sovereign states.

Dexia is the first manifestation of this increased stress and the question now is whether this is a harbinger of events to come or whether the collective action of the policy makers can contain the growing crisis through an ambitious bank recapitalisation plan, as the US achieved with its troubled asset relief programme (TARP) in 2008.

This note will consider if other banks are vulnerable to insolvency risk as a result of the sovereign debt crisis and whether the Eurozone authorities can deliver an effective rescue plan.

It compares and contrasts the proposed European recapitalisation to the US TARP and looks at the obstacles and challenges that the authorities face in delivering a credible plan.

Why has contagion spread to the banking sector?

After the second Greek bailout at the end of July failed to prevent fear of default spreading to the larger periphery countries, Italy and Spain, the banking sector was quickly dragged into the crisis.

This was the moment when the debt crisis moved from amber to red and markets reacted accordingly.

Despite the EBA stress tests it was well known that many Eurozone banks were vulnerable to a default scenario.

Crucially, this was something that was not tested in either of the EBA stress tests.

The package agreed for the second Greek bailout included a write down of its debt. This represented a modest 21% of the total but some banks wrote down a more realistic 50% in their balance sheets.

The effect on the capital base and earnings of the banks spooked the market and those banks’ share prices, especially the large French banks, went into freefall.

Furthermore, the CDS of these banks rose and have continued to rise to levels well above what was seen after the demise of Lehman Brothers at the height of the crisis in 2008.

Even before the crisis spread to Spain and Italy the banks had shown signs of funding stress and, as in other developed economies, it is the banks’ reluctance to lend that has forestalled the recovery.

This is because credit has not been extended into the real economy, thus crimping demand.

Banks were much more dependent on funding from the ECB’s liquidity facilities and had been depositing money with the central bank in larger quantities than is normally the case reflecting their reluctance to lend.

These trends accelerated after the sovereign debt crisis deepened in August and the ECB responded by improving its access to its liquidity facilities and other central banks, including the Bank of England and the US Federal Reserve, joined the ECB in easing conditions for dollar funding that had become prohibitively expensive.

Last week the ECB extended these liquidity measures still further including agreeing to purchase €40bn of covered bonds. The charts below show how the banks have increased their reliance on the ECB for liquidity with the second chart illustrating how Spain and Italy, in particular, have increased dependence on the ECB.

However, despite the positive response by central banks it did not allay the market’s fears about the fragility of the banking sector.

On the funding side the conditions in the private sector have gone from bad to worse. There has been virtually no public issuance of wholesale debt for several months (an important source of liquidity) and interbank lending plunged for any banks that were perceived to be exposed to the sovereign debt crisis in a meaningful way.

This was what brought Dexia down.

Despite the ECB facilities, the counterparty confidence between Dexia and other banks fell to such an extent that it raised concerns over its solvency and necessitated a joint rescue to be proposed from the French, Belgian and Luxembourg governments.

Part of the problem with Dexia, that had been marked down as one of the most capitalised banks in the recent EBA stress test, was that the sovereign bonds in its books were not written down to market value and, if they were, it would erode a significant, and unsustainable, amount of its capital base.

It is the issue of solvency that the markets really fear just as it is with the sovereign states themselves. In addressing the debt problem at national level the authorities have concentrated on providing liquidity solutions to allow the respective countries to keep financing in the vain hope, at least so far, that economic conditions and better fiscal management through austerity programmes, will restore solvency. To some extent, the action of the central banks, thus far, replicates this strategy.

In 2008, although there was a liquidity crisis, it was when Lehman’s became insolvent that the crisis really erupted because of contagion to the rest of the financial sector that further insolvencies would follow. If it had not been for the prompt and direct intervention of the authorities, especially in the US and UK, there would have been many more bankruptcies. This is why it is so important that the European authorities deliver a credible version of their own TARP before it is too late.

What do the Eurozone policy makers need to do to help the banks and can it be achieved?

A good reference point is the US TARP that successfully recapitalised the US banks at a time of acute financial stress and in the face of much resistance and scepticism. The Act was signed by President Bush as soon as October 3rd 2008 which was less than a month after Lehman’s went bust on September 14th.

The quick response was rendered necessary by circumstances, like now, when markets went into freefall after the Lehman’s event.

The investment bank was the counterparty in so many derivative transactions that it triggered unsustainable losses throughout the financial system. Even after it was signed, however, it did not lead to a sustained rally in US banks, as the chart below shows, as it required other policies to be agreed, notably QE from the Federal Reserve. The fact that TARP was necessary but not sufficient for the US is relevant to Europe now and is discussed below.

Despite the gravity of the situation, the planned rescue of the banks in the US was initially met with considerable resistance. The banks insisted that they did not need asset relief and it was rejected by Congress. In order for it to become law, executive powers had to be invoked that allowed new laws to be created in emergency situations. The idea was originally for the Treasury to buy the toxic assets of the financial institutions in order to clean up their balance sheets.

This was later rejected, partly following the lead from the UK, to inject capital into the banks themselves. The TARP fund was created with a massive $700bn of firepower in order to remove any doubts about the government’s intentions to tackle the problem.

The Treasury was immediately given $250bn and the rest was allocated later. By the time the final tranche was allocated in March 2009, the current Treasury Secretary, Tim Geithner, was in office and it is his experience and advice that has recently provided impetus to the idea of a European bank bailout.

The pragmatism of the US government at this time is very instructive in providing guidance to the European policy makers who have found it so difficult to achieve common ground. Bailouts are always unpopular, as we have continually seen in the Eurozone countries during the last 18 months, but sometimes the collective needs of the nation (or in the case of the Eurozone, the currency union) must override the individual interests of a particular bank or country.

In the US, the Treasury Secretary at the time, Hank Paulson, was a strong willed individual who used the power of the Executive to force the bill through and persuaded the banks, despite their initial reluctance, to accept it.

Europe needs a person of similar stature now to provide the impetus for such legislation but given the disparate nature of the Eurozone, in contrast to the single and unified constitution of the US, it is more difficult to see who is going to act as a driving force to get the deal done. In Europe, the political leaders are answerable to their own electorates rather than the common cause and this conflict of interests has stymied decision making throughout the debt crisis. If a leader with vision is to emerge it is more likely to be from one of the supra-national bodies such as the ECB or the European Commission.

The retirement of Jean Claude Trichet as President of the ECB means he is no longer a candidate to assume the role but Jose Barroso, the EC President, has recently made speeches in an effort to accelerate moves towards a fiscal union, so perhaps he could prove to become a figurehead.

There is no doubt that there is consensus that the bank sector needs more capital despite the stress tests taking an opposing view. Some of the banks have denied the need for extra capital but this is not surprising and is also consistent with what happened in 2008. Lehman’s, almost up to the day it was allowed to go bust, argued that it was in good financial shape.

This is not just bluster but reflects the fact that, in isolation with the banking system working normally, these banks can operate profitably within the constraints of their respective balance sheets. In reality, of course, banks are dependent on the rest of the financial system and the holders of their assets having confidence in them. Without that, they are effectively insolvent several times over at any one time and a dramatic loss of confidence can lead to a run on the bank in an extreme situation, as Northern Rock discovered in the summer of 2008.

Recent discussions at the IMF, at the end of September and more recently between Sarkozy and Merkel, have suggested that a bold plan is being formulated that aims to be sufficiently large to help build a firewall around the banking sector from the sovereign debt contagion. There are also rumours of a further and, importantly, realistic stress test on the banks that includes mark to market valuations on the banks’ Greek debt holdings to be followed by capital injections to make the banks recession proof. However, there are several questions that need to be answered in assessing whether such a plan is workable and has a realistic chance of success.

What size does the bank recapitalisation plan have to be?

The plan to recapitalise the banks was only given impetus when the IMF said publically and controversially that the banks required up to $200-300bn of new capital.

This was way in excess of what had been implied by the EBA stress tests in July and appeared to give official confirmation that the banks were significantly undercapitalised in the event of a major sovereign default. The bar chart below is based on a recent survey of how much is needed to effectively recapitalise the banks. It is interesting that only 4% of participants thought less than €100bn would suffice, a figure that was much above what the EBA thought was necessary.

Since the IMF announcement, other analysts have also calculated their own estimates based on the banks holdings of periphery sovereign debt and different scenarios of write-offs of that debt. For instance, Nomura reckon that a 21% write down (the amount of debt relief that Greece has already received) on all periphery debt would require about $400bn to be injected; the Lex column in the FT last week postulated a figure of €675bn that is bigger than the $700bn for the US TARP programme.

It is not only the direct impact that a write down of sovereign debt default would have on balance sheet assets, but also the indirect default. If periphery governments are forced to have haircuts on their sovereign bonds it is likely to have significant repercussions on private sector debt holdings and the broader economies. The BIS estimates that the German and French banks’ exposure to the private sector of the periphery countries is around €640bn and, therefore, a 20% write down of private sector debt would represent a loss of €128bn in addition to the sovereign debt defaults.

There is no doubt that to succeed the size of a bank recapitalisation plan needs to be big enough to shock the markets. In the words of the US Treasury Secretary at the time, Hank Paulson, a ‘bazooka’ approach needs to be used and the UK Prime Minister, David Cameron, has repeated this phrase last weekend. TARP succeeded partly because $700bn was a sufficiently large sum that it was credible to address the massive problem of sub-prime debt in the US banking system. Perhaps an even larger sum is required now. It does not, however, mean that the money will be lost by the tax payer forever. In the US, it is estimated that the tax payer has only lost about $50bn of the original $700bn as the growth in bank assets and earnings allowed most of it to be repaid. There have been similar successes in Sweden and Japan although in the UK the taxpayer is still heavily in loss.

Who is going to fund the bail out of the banks?

One of the factors that makes the recapitalisation of the European banks more cumbersome than the US TARP is that many countries are involved in the decision making process and, furthermore, the legislation process is one of Byzantine complexity compared to the facility with which the new laws were forced through in the US.

According to reports there appears to be a fundamental disagreement between the two dominant members of the Eurozone, France and Germany. France is keen to use the common bailout fund, EFSF, to pay for the bank recapitalisations whereas Germany would prefer national governments to foot the bill and only use the EFSF as a last resort. France’s preference is mainly one of self interest; the country has some of the most exposed banks in Europe to the periphery sovereign states and if it was forced to pay for it internally, it would raise its own debt/GDP ratio to a level that could imperil its AAA credit rating status.

Belgium, following the recent demise of Dexia is a case study in this respect. The bailout of the bank has led to Belgium’s debt/GDP ratio rising to over 100% - in response it was placed under watch by one of the credit rating agencies and its benchmark bond yield rose to over 4%. The French President has said it is committed to maintaining its top rating and if it was lost it would undermine the efficacy of the EFSF that can only disburse funds subscribed by nations with AAA status.

From Germany’s point of view, as a relatively strong financial member of the Eurozone it would make sense for it to finance its own bank bailouts. There is no danger that it will lose its AAA status and the yield of the bunds has fallen steadily recently on the back of their safe haven status. However, it should be noted that the CDS for Germany has risen as the bond yields have fallen, which may be a more accurate barometer of the increased risk of Germany’s involvement and potential liabilities from the crisis. According to reports at the weekend of the discussions between Merkel and Sarkozy, they ended ‘’in accord’’ with Mrs Merkel saying that the nations were ‘’determined to do the necessary to ensure…recapitalisation of Europe’s banks’’. It will be interesting to see what compromise has been agreed when the details of the deal emerge.

Whatever option the policymakers choose it is going to represent a formidable challenge. Ideally, subscription of capital from the private sector would make the job a lot easier but this is unlikely to be forthcoming. Share prices have collapsed making equity issuance too expensive and term finance through the wholesale debt market has been almost non-existent for several months (see chart below showing how recent issuance has fallen away). Injections of capital from overseas sovereign wealth funds have attracted a lot of rhetoric but little of substance and they will be reluctant, having lost huge sums in the earlier credit crisis. Therefore, the money will have to come from the public purse.

It is likely that the deal will involve a combination of both funding from national governments and the Eurozone bailout fund, the EFSF. Some countries will not be able to afford to recapitalise their banks and other countries, especially France, would not want to jeopardise their public balance sheet for fear that it could affect their ability to fund themselves. This was never a problem for the US for, despite its high debt/GDP ratio and annual deficit there was not a perceived sovereign debt problem in 2008 and, as we have seen recently, the US enjoys preferred creditor status despite its high debt ratios. Therefore, any plan would work better if it was able to allay fears of national governments not being able to pay for recapitalisations of the banks or affecting their future credit rating adversely.

One complication is that the EFSF’s involvement would necessitate an enlargement of the fund. As part of the enhancement of the EFSF with the second Greek bailout no increase in resources was agreed. When the new measures are ratified by all 17 members of the EMU it will have €440bn available for disbursement but already over €100bn has been earmarked for the existing bailouts of Greece, Portugal and Ireland leaving only about €330bn. It is agreed this is grossly insufficient to cover any future national bailouts as well as the bank recapitalisation plans but how are the EFSF’s resources to be increased given the need is urgent?

To avoid the time consuming and uncertain legislative process (including treaty amendments) the most likely ‘solution’ to raise the firepower of the bailout fund is to leverage it. I believe this is a dangerous proposition and will only redistribute the liabilities of Eurozone within it. It is an example of financial engineering analogous to the asset backed securities that were created from a limited equity base by the US investment banks for the housing market. This gave birth to CDO, and other exotic products, and was the genesis of the current credit crisis.

Apart from whether it will work or is a good idea, it is likely to face resistance from the ECB that will probably have to get involved to enable the EFSF to be geared. It may also be a contravention of the ECB’s mandate. The German finance minister has dismissed it as a ‘stupid idea’ and the principles of sound finance espoused by the ECB and the German bundesbank would be undermined if such a proposal were adopted. The recent rise of the ECB’s bond yield is a reflection of the lower quality that would be ascribed to the EFSF’s own balance sheet (see chart).

Will a major bank recapitalisation plan be sufficient?

Perhaps the key question is whether a comprehensive bank recapitalisation plan will be sufficient to provide the basis for a sustainable solution to the Eurozone debt crisis. Again looking back at what happened with the US TARP is instructive.

In 2008 the credit crunch originated in the sub prime mortgage sector in the US. The investment banks had created a new technology of debt through various asset backed securities (ABS) such as collateralised debt obligations (CDO). These resulted in spectacular rises in profits from the originators of the new debt and were justified by the notion that it defrayed the risk by passing it to other parties within the financial system. Indeed, the credit rating agencies did not downgrade the banks and mortgage agencies until after the crisis erupted because the risk of the new debt instruments was not recognised.

After Lehman’s went bust the epicentre of the problem was the derivative contracts that had been triggered as a result of its insolvency. These resided right across the global financial system and especially within some of the leading US financial institutions, which threatened to lead to a breakdown of the global banking system. Therefore, the most urgent task was to provide capital to the banks and other financial institutions that were most at risk which is what TARP successfully achieved.

In the Eurozone the key difference is that the banks are a symptom rather than the cause of the crisis as they were in 2008. While it is necessary to stabilise the European banking system it is not sufficient to provide a sustainable solution. This will only come from addressing the cause of the crisis which is the sovereign debt issues in periphery countries in the EMU arising out of their long-term lack of competitiveness. For a permanent solution to be found it will require a break-up of the Eurozone or full fiscal union and only if one of these solutions is achieved will it prove to be sufficient.

The recent meeting at the IMF and the talks between Merkel and Sarkozy have alluded to more comprehensive measures in addition to plans to recapitalise the banks. It appears there will be an agreement to enhance the firepower of the EFSF and a larger write down of Greece’s debt, above the 21% already agreed, including higher private sector participation. While this does represent another step towards full fiscal integration for the Eurozone it is a far cry from full fiscal and political union which, I believe, is necessary for the Union to work efficiently and to be able survive another major economic crisis.

On the contrary, the tentative plans to financially strengthen the EFSF represent an extension of the existing strategy, which has consistently failed, of providing more liquidity to help funding needs of the weaker countries while insufficiently addressing their solvency and competitiveness problems. Until the policy makers accept that a fundamental change of strategy is necessary I believe that any interim measures, even involving a large recapitalisation of the banks will only buy time and ultimately are likely to fail.


The decision to recapitalise the Eurozone banking sector is a welcome and necessary development as the contagion had threatened to spiral out of control. The blueprint for the recapitalisation plans is the successful TARP legislation passed in the US shortly after Lehman’s became insolvent in September 2008.

However, the obstacles for the European policy makers are significantly larger: firstly, in being able to implement a plan in an effective time frame and, secondly, as to whether it will be sufficient to provide the basis for a sustainable solution to the debt crisis. With regard to the latter point the heart of the crisis is one of sovereign debt, and the fears of bank liquidity and insolvency are a symptom of the broader issue of national indebtedness and not the cause itself.

The key to resolving the crisis is to be able to sever the Gordian knot that ties the peripheral sovereign debt to the banking sector. The chart below illustrates how sovereign risk has been the main driver of Eurozone banks’ performance and, so far, policy response has failed to break the interconnectedness.

Until a comprehensive plan is implemented that creates a full fiscal union or results in a break up of the Eurozone that is necessary to ensure its long term survival, the authorities will only be able to buy more time. A bank recapitalisation plan as part of a Grand Plan involving a more powerful bailout fund and further debt relief for Greece is positive news but, ultimately, it is another sticking plaster, albeit a much bigger one.