Still Too Big To Fail?

 Still Too Big To Fail?

If another sector fit the description above – bloated, with too many inefficient competitors scrapping over a highly-regulated, barely-profitable market – the solution might be to let competition do its bloody work. Unfortunately, as the world saw in 2008, some institutions are too big to fail.

           

When Lehman Brothers radioactive portfolio of mortgages began to threaten the bank's future in mid-2008, CEO Richard Fuld hunted for any sort of rescue, be it a fresh investment, a merger, a buy-out, a change to Federal Reserve rules or an outright bailout. The bank ran out of options and declared bankruptcy on September 15, 2008, an event that laid bare the fragility of the global financial system.

Over the following days, hedge funds that traded through Lehman's London office found that their assets were frozen, sowing panic behind the scenes. The crisis erupted into plain view when major money market funds "broke the buck" – announced they would not be able to repay investors in full – sparking a flight from a commercial paper that threatened to deprive large corporations in every sector of the cash they needed to pay workers and invoices. Gargantuan, system-wide government bailouts stopped the bleeding, but the world still feels the effects of a crisis triggered by a single bank failure eight years ago.

Monte dei Paschi di Siena

On Wednesday, December 21, Italy's parliament approved a €20 billion rescue package for the country's weakest banks, beginning with its third-largest and most precarious, Monte dei Paschi. The news caused shares to recover slightly after plunging 19.1% – pausing for a trading halt – to €15.00; markets punished the already limping stock after Monte dei Paschi announced Wednesday that its €10.6 billion liquidity position would run out in April, seven months earlier than previously forecast.

The bank continues to try to raise private money in a €5 billion recapitalization effort. The ECB has given it until the end of 2016 to raise the money and dispose of €27.7 billion in bad loans – the net value of which is estimated at €9.2 billion. It has threatened to wind Monte dei Paschi down if it fails to do so. On December 9, the central bank rejected a request for a three-week extension, yanking Monte dei Paschi's shares down by nearly 11%.

As part of a plan developed by JPMorgan Chase & Co. (JPM) and unveiled in October, the struggling lender began exchanging subordinated bonds for equity in late November, raising around €1 billion by December 2. The plan was to supplement money raised through the debt-for-equity swap with an anchor investment. To sweeten the deal, the bank said it would target €1.1 billion in net profit by the end of 2019. It has already eliminated its dividend; to cut costs further, it announced that it would slash 2,600 jobs and shut 500 branches. Bank of America Merrill Lynch analysts were skeptical, asking in a research note if it is "even possible" to raise €5 billion in fresh capital for a €550 million company (at close on October 25). Apparently not. The Financial Times reported Wednesday that the bank had failed to secure a €1 billion anchor investor from a Qatari government fund, prompting the €20 billion bailout.

The failure is due to a number of factors, but politics is front and center. Along with the news that Monte dei Paschi's swap had come up short on December 2 came reports that the government was in discussions with the European Commission regarding the terms of a bailout for the bank. A referendum on constitutional changes championed by then-Prime Minister Matteo Renzi was scheduled for December 4, and a litany of precedents – Trump, Brexit, the FARC deal, Greece's rejection of the Troika's bailout terms – seemed to indicate that Italy's voters were in no mood to go along with their government's plans. Sources had told the Financial Times at the beginning of the week that, if the referendum were rejected, eight of Italy's weakest banks could fail.

Italians did not disappoint, voting "No" to Renzi's reform plans by a staggering 20 percentage point margin. Renzi resigned and was replaced by Paolo Gentiloni, the minister of foreign affairs. Given that the Democratic Party clearly lacked popular support for its agenda, private investors feared that a less predictable government, led by the Five Star Movement or the far-right Northern League, could come to power. Both parties are hostile to the single currency: Northern League leader Matteo Salvini called it "a crime against humanity" in 2013, while former comedian and Five Star Movement leader Beppe Grillo has campaigned for a referendum on leaving the eurozone.

On December 7, Reuters reported that the Italian government was preparing to take a controlling stake of up to 40% in Monte dei Paschi, in what an unnamed source called a "de-facto nationalization." The €2 billion injection was reported to take the form of bond purchases by the Treasury: retail investors numbering around 40,000 would receive face value for their bonds, which the government would then convert to shares in the bank. According to a Financial Times report Wednesday, Rome is likely to take a majority stake, perhaps up to 70%. The government will have to go deeper into debt to fund the bailout: according to UniCredit economist Loredana Federico, the rescue package is likely to increase Italy's debt-to-GDP ratio – already the eurozone's highest, bar Greece – to over 134% in 2017, from a previously forecast 133.2%.

Monte dei Paschi pressed on with its private recapitalization effort anyway, relaunching on December 16 the debt-for-equity swap that had ended earlier in the month. Although the bank's shares are practically worthless – if it weren't for a 100-to-1 reverse split in late November, they would be worth less than €0.20 each – the prospect of seeing the bank's bonds lose their entire value in a bail-in pushed more investors to take the trade. Just not enough: the swap, which ended Wednesday afternoon (local time), is reportedly on track to raise €1.7 altogether, far short of the goal – particularly without a fresh investment from Qatar. A fresh share sale, launched on Monday, also flopped.

Atlante, a fund set up to rescue Italy's banks, said Wednesday it would not go through with a €1.5 billion investment in the bank's bad loans unless the state's cash call was limited to €1 billion and did not violate EU state aid rules.

Bail-in

Barring a miracle, Monte dei Paschi is set to take public money. According to EU rules implemented at the beginning of the year, it must first receive a bail-in, meaning that junior bondholders must take a loss amounting to 8% of the bank's assets before bailout money can flow in. In countries where bank bonds are mostly held by institutions, that might not be a disaster, but Italy's tax code and cultural norms encourage retail investors to hold bank bonds – around €200 billion nationwide. A much smaller bail-in caused an Italian saver to kill himself in December 2015. Reports are focusing on the possibility that investors will be compensated, but nothing has been definitively worked out.

The hope is that, once the Italian Treasury has become the bank's controlling shareholder (it is already the largest, with a 4% stake), private investors will be confident enough to fill in the gap left by the debt-for-equity swap and the government's investment.

Renzi tried for months to convince Brussels to allow for the use of public money, but Germany and others in Europe's "core" were in no mood for taxpayer-funded bailouts. "We wrote the rules for the credit system," German chancellor Angela Merkel, who is facing elections in 2017, told reporters in June. "We cannot change them every two years." In the wake of the referendum, circumstances appear to have changed.

A Long-standing Problem

Stress tests conducted by the European Banking Authority in July found that nearly eight years after the financial crisis began, the continent still harbored at least one bank liable to walk off a cliff in a downturn. Monte dei Paschi saw its fully-loaded common equity Tier 1 (CET1) ratio, a risk-weighed measure of capital, fall to -2.4% in 2018 under the test's adverse scenario. In other words, the bank would be insolvent, and its collapse could potentially lead to other bank failures. It was the only one among 51 banks surveyed to earn that distinction, though struggling Greek, Cypriot and Portuguese banks were excluded from the test.

Monte dei Paschi's struggles were well-known going into the stress tests. The lender had unveiled a restructuring plan just hours beforehand, showing it was not banking on a pleasant surprise. Founded in 1472, Monte dei Paschi is the world's oldest surviving bank, but in this case, antiquity does not imply stability. Prior to the first quarter of 2015, when it turned a modest profit, it had lost money for 11 straight quarters – over €10 billion in total. In the three months to September, the bank swung to lose again, of €1.2 billion.

Shortly before Europe's financial crisis struck, Monte dei Paschi bought Antonveneta from Banco Santander S.A. (SAN) for an inflated €9 billion. In 2013 that acquisition – funded by a complex hybrid instrument designed by JPMorgan – became the subject of an investigation that also uncovered complex derivative contracts with Deutsche Bank and Nomura Holdings Inc. (NMR), which Monte dei Paschi management had used to conceal losses in 2009. Three former executives received 3.5-year prison sentences in connection with the fraud in 2014.

Monte dei Paschi took a €1.9 billion bailout in 2009 in the form of Tremonti bonds, named by the finance minister at the time. These were hybrid securities designed for sale by struggling banks – four in all, three of which had repaid by mid-2013 – to the Italian government; the proceeds counted towards regulatory capital requirements. Monte dei Paschi ducked out of the European bailout of Spain's banking system in 2012, but the following year it sold Italy €4.1 billion in rejiggered Tremonti bonds (known as Monti bonds after Tremonti's successor). Of this sum, €2.1 would substitute for the first bailout, including interest. The bank has raised around €8 billion through additional rights issues since 2014, diluting previous shareholders' stakes, yet its market capitalization as of December 20 is a mere €501 million.

Deutsche Bank

Ironically, given Merkel's avowed reluctance to bail out banks, the other European institution that keeps markets up at night hails from Germany. In June, the IMF named Deutsche Bank "the most important net contributor to systemic risks" among the so-called global systemically important banks (G-SIBS).

Linkages among global systemically important banks. The Size of bubbles indicates asset size; thickness of arrows indicates a degree of linkage; a direction of arrows indicates the direction of "net spillover." Source: IMF Financial System Stability Assessment, June 2016.

On September 15 the angst surrounding Deutsche Bank deepened when it confirmed reports that the Department of Justice (DOJ) was seeking a $14 billion settlement for alleged wrongdoing related to mortgage-backed securities from 2005 to 2007. The bank's New York-listed shares plunged by over 9% the next day, as it had only €5.5 billion set aside for the purpose – less than the €6.8 billion it had lost the previous year. (A couple of weeks later, Greece's central bank chief relished the opportunity to announce that his country's banking system was safe from German spillover.)

On Thursday, December 22, the bank announced that it would pay a reduced fine of $7.2 billion, consisting of a $3.1 billion civil monetary penalty and $4.1 billion in consumer relief in the U.S., primarily in the form of loan modifications. Even with the diminished fine, though, Deutsche Bank is in a precarious position. As of September 30, it had €5.9 billion ($6.4 billion) set aside for litigation expenses, up from €5.5 billion at the end of the previous quarter. JPMorgan analysts wrote on September 15 that a final bill over $4 billion would raise questions about the bank's capital position. They pointed out that the mortgage-backed security probe is not the last potentially costly legal issue Deutsche Bank could face in the near future: investigations into money laundering for Russian clients, foreign exchange rate manipulation and sanctions violations are also underway.

Few had expected Deutsche Bank to pay the full $14 billion, which could have pushed it over the brink. Citigroup Inc. (C) talked the DOJ down to $7 billion in 2014 from a $12 billion initial ask. Other fines for similar activity range from Morgan Stanley's (MS) $3.2 billion to Bank of America Corp.'s (BAC) $16.7 billion.

Following the announcement that the DOJ was seeking $14 billion in September, speculation began to swirl that Germany would flout the bail-in rules it had expended such political energy to defend, though Merkel has ruled out state assistance, according to government sources quoted in Munich-based Focus magazine.

Deutsche Bank's CET1 capital ratio has fallen since the end of 2014, though it rose slightly in the third quarter of 2016 to 11.1%. At 10.8% in June, the ratio was around €7 billion shy of CEO John Cryan's 12.5% end-2018 goal. Selling Postbank and its stake in Hua Xia Bank Co. Ltd. will likely bring Deutsche Bank closer to that target, but stricter rules could push its capital ratio even lower.

While Deutsche Bank has taken a few heavy losses since the financial crisis in Europe began, it could conceivably have built up more capital through retained earnings and avoided looking so brittle when the DOJ came knocking. John Cryan, the bank's CEO since July 2015, has set his sights on executive pay, telling a conference in Frankfurt that November, "many people in the sector still believe they should be paid entrepreneurial wages for turning up to work with a regular salary, a pension and probably a health-care scheme and playing with other people's money." Chief financial officer Marcus Schneck told investors on October 27 the bank would dispense with cash bonuses for the year and may tie executive compensation to the stock price. On November 17 Süddeutsche Zeitung reported that Deutsche bank may cancel six former executives' unpaid bonuses, without specifying the amount. In fairness, shareholders have taken a greater share of earnings than executives – though not per head – in the form of dividends, which were discontinued in 2015.

Better-than-expected third-quarter earnings of €278 million, announced on October 27, have given Deutsche Bank a moment to catch its breath, but the firm remains vulnerable, and it does not have to be the European banking crisis' zero cell to contribute to the carnage – it could serve as a conduit. Deutsche Bank reported net exposure to Italian financial institutions of €1.9 billion at the end of the third quarter, up €1.1 billion from year-end. Its net credit risk exposure to the PIIGS countries is €31.1 billion, up €4.9 billion.

Will There Be a European Banking Crisis?

The ultimate question is whether, if one of these banks or another were to collapse, the world would see a repeat of the Lehman moment. Kevin Dowd, professor of finance and economics at the University of Durham, answered this question in stark terms in an August report for the Adam Smith Institute: "Once contagion spreads from Italy to Germany and then to the UK, we will have a new banking crisis but on a much grander scale" than in 2007 and 2008.

Not everyone agrees. "No, I don't see them as the next Lehman," Harvard Law School professor Hal Scott told Investopedia on October 31. "I think that there are problems that are idiosyncratic to some extent to each bank. I don't see panic ensuing from how they're dealt with." In fact, he sees the European banking system as having "more capability to handle a contagion than in the United States," due to Americans' unwillingness to see a repeat of the 2008 bailouts.

Scott explained that European authorities have three "weapons" that would allow them to put a stop to financial contagion "pretty quickly." First is the ability of national central banks to act as a lender of last resort, although the ECB can cap the amount these banks lend. "I'm pretty confident that the Italian central bank and [German] Bundesbank would lend," he said, adding, "I think there would be a strong lender of last resort response in Europe."

The second weapon is the Single Resolution Mechanism, what Scott called a form of "standing TARP," which envisions the use of banking industry contributions, creditors' money and public funds to resolve failing banks. Finally, while the EU lacks a system-wide deposit insurance scheme, there are rules governing national schemes, which guarantee up to €100,000 per depositor per bank.

While Scott does not see Deutsche Bank or Monte dei Paschi setting off another Lehman-like chain reaction, he identified flaws in the European banking system's current design. It would be better, he said, if the ECB acted as the lender of last resort rather than national central banks. He is also doubtful of capital requirements' ability to stem a panic: "in a run on a system, no amount of reasonable capital is going to be sufficient." Such requirements are a good thing, he clarified, like enhancing a building's ability to withstand fire – even so, "you don't abolish the fire department."

If and when something goes wrong in Europe's fragile banking system, avoiding a full-blown financial crisis in Europe will likely depend on policymakers' ability to quickly reassure markets and depositors. According to Scott, national and continental authorities' capabilities are "more than adequate." On the other hand, judging by the state of Europe's banks nearly a decade after the initial crack-up, resolving crises quickly may not be the continent's strong suit.

Chuck Reynolds
Contributor