Europe’s banks have slashed their holdings of sovereign debt issued by the peripheral nations of the eurozone, selling 65 billion euro ($87 billion) of it in just nine months.
The sales – largely to the European Central Bank (ECB) and a clutch of hedge fund investors, according to bankers – represent 13 percent of the banks’ holdings, cutting their total exposure to Greece, Ireland, Italy, Portugal and Spain to 513 billion euro.
The banks’ sovereign holdings were made public late on Thursday as part of a European Banking Authority stress test, which also revealed an increase, from 106 billion euro to 115 billion euro, in the capital that the regulator has told the banks they must raise by next June.
But the scale of the sovereign debt sell-down only emerged after comparing the new disclosures with a similar exercise conducted in the summer.
BNP Paribas cut its holdings by the most, shedding nearly 7 billion euro of the sovereign debt of Greece, Italy, Ireland, Portugal and Spain and leaving it with 28.7 billion euro as at end-September. Deutsche Bank’s 6 billion reduction was by far the biggest in percentage terms (66 percent) and left the bank with just 3.2 billion euro of GIIPS exposure.
Of the 65 banks whose sovereign holdings were published by the EBA, 55 cut their exposures. But, in an unexpected twist, 10 actually increased their holdings of government debt in the peripheral euro zone. The charge was led by Spanish banks, principally Bankia, which bought a combined 4.9 billion euro of Spanish and Italian debt. BBVA also increased its Spanish government debt holdings by more than 1 billion euro.
Even more puzzling was the 3.7 billion euro jump in GIIPS exposure at Landesbank Baden-Württemberg, as the lender stocked up on Italian, Spanish and Portuguese government debt.
Analysts at Citigroup also highlighted how LBBW and two other Landesbanken – WestLB and NordLB - were big writers of sovereign CDS protection, a form of insurance against default. Along with Austria’s Volksbank, the three state-owned German banks were the largest players in that market relative to their capital bases, a potential issue in case there were sovereign defaults.
The sell-down in sovereign debt exposures has taken place steadily over the year as banks have sought to reduce investment risk. But it appeared to accelerate when it became clear in the summer that the EBA would force banks to value sovereign debt in line with market prices, in effect applying a capital deduction to holdings. The smaller the GIIPS sovereign exposure a bank has, the less its capital position is penalized by the EBA.
However, some observers now believe the trend of selling out of such debt could reverse. The European Central Bank’s decision on Thursday to extend the duration of its loans to banks from one to three years, paired with less stringent capital requirements, could give lenders an opening to pile back in to sovereign debt – at least in the eyes of euro zone leaders, who gathered in Brussels on Thursday in the latest attempt to thrash out a solution of the continent’s crisis.
Nicolas Sarkozy, French president, on Friday outlined what he expected would happen as a result of the central bank’s move.
“Italian banks will be able to borrow [from the ECB] at 1 percent, while the Italian state is borrowing at 6-7 percent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.”
The EBA has said it will do no further tests of banks’ capital adequacy between now and June, meaning that the banks would not be required to raise additional capital on top of current estimates. But finance experts question both whether the banks will be tempted by the arbitrage between low ECB rates and government bond yields described by President Sarkozy, or whether it was desirable they should.
“Banks borrowing from the ECB to then buy sovereign bonds is not a sustainable strategy either for the banks or the sovereigns. People will question how long this will be allowed to go on,” said Sony Kapoor of Re-Define, an economic think-tank.
“By doing this, you are strengthening the link between banks and sovereigns, which has proven so dangerous in this crisis. Even if useful in the short term, it would seriously increase the vulnerability of both banks and sovereigns to future shocks,” he added.
The trade could be made more attractive by another decision made at the summit: to exclude the possibility of “private sector involvement”, or impose haircuts on the holders of sovereign bonds of countries that go on to receive bail-outs, as happened in Greece.
ECB policies have in the past opened up opportunities for banks to buy short-term bonds with central bank loans with a duration of up to a year. But the extension of the loan duration to three years will make it easier for banks to purchase longer-term paper.