The return of the sovereign-bank loop?

Posted by Tracy Alloway on Jun 20 10:37.

Exactly where you wouldn’t want it, too. Spain.

FT Alphaville readers will remember that a whole bailout-load of eurozone debt worries kicked off once banks started buying up their respective government bonds post-financial crisis. Greek banks bought Greek bonds. Irish banks bought Irish bonds. Spanish banks bought Spanish bonds and so on.

When it comes to Spain, though, things got a little better at the start of 2011. Dependence on ECB financing went down, which meant the banks didn’t need so many bonos to use as repo collateral. But circumstances have been a bit hairier recently. Spanish bank borrowing from the ECB rose from €42bn in April to €53bn in May, and there was also a busted auction of €1.5bn of Spanish debt last week.

So are we about to see Spanish banks relying on Spanish bonds/ECB financing again?

Here’s Deutsche Bank’s Gilles Moec:

Further increases in reliance on ECB funding may appear in the coming months, as an indirect consequence of the government’s decision to put an end to the “deposit war” which has been opposing Spanish banks for the last two years. Indeed, in order to beef up their liquidity position, credit institutions started to offer very generous remunerations to attract deposits. Under a new system, to be implemented from 3 July onward, their contributions to the Deposit Guarantee Fund – a fixed percentage of outstanding deposits – will be multiplied by 5 for deposits paying more than 100 or 150bps above EURIBOR. While the “deposit war”, by eroding Spanish banks’ profitability, had become a medium-term vulnerability for the country, in the short run it may force some credit institutions to rely more on ECB lending to offset lesser deposit dynamics.

The state of the Spanish banking system will probably remain a market focus as long as no full clarity on the recapitalisation/restructuring process for the Cajas is available. Under the current timeline, while the results of the stress tests – just as for the rest of the EU – will come out probably in early July, the amount of cash that the state is ready to pour into the Cajas via the FROB will not be known before 30 September. In the meantime … the most pressing issue for the Spanish government on these matters will be to ensure that the FROB has enough space for its issuance in the last 3 months of this year, and this implies a continuation of the “over-issuance” for the sovereign. Over the first 4 months of the year, bonds and bills issuances exceeded by EUR 16bn funding needs.

However, paradoxically, that Spanish banks may be faced with some “market funding drought” may help the sovereign go through a delicate patch this summer, faced with the necessity to continue to over-issue against a background of a large refinancing spike in July (EUR21.4bn in our estimate).

Looking for collateral, Spanish banks may be readier to take a large share of government bonds. Last year, when Spanish banks were resorting quite heavily on ECB lending, their participation to government funding was also significant, even if non-residents still accounted to roughly half the holdings in Spanish sovereign bonds (see Figure 2). The peak in ECB lending also corresponded to the peak in banks’ exposure to government debt. Conversely, when the bond market re-opened to Spanish banks in late 2010/early 2011 and reliance on ECB lending diminished, the share of banks in government funding also declined. Collateral management probably is the cause of this correlation.

A re-instatement of the banks/sovereign financing loop cannot be sustained in the long run, but it may be an acceptable transitory patch if it allows for a final resolution of the banks’ capital gap by the end of this year, which we note is, intrinsically, the very source of Spain’s difficulties in the market.

A self-funding summer for Spain. Let’s hope the market doesn’t notice.

Related link:
Bias in bonds – FT Alphaville

This entry was posted by Tracy Alloway on Monday, June 20th, 2011 at 10:37 and is filed under Capital markets. Tagged with , , , , , , , .

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