Cyprus may not be a template but as Pawel Morski said, the actual template is probably not going to look all that different.
We’ve already written a little bit about this and on Thursday Barclays published a note suggesting the Cyprus mess, plus the incoming common resolution framework, might wipe €15bn annually from the profits of Europe’s biggest banks. The draft of said framework is scheduled to come into play by 2015 with the bail-in tool, which had been delayed until 2018, perhaps being moved forward. We await clarity from European legislators this summer, if the summer ever arrives.
Concerning Barclays’ €15bn figure, it’s made up of a few different, but connected, elements.
First, as Frances Coppela put it: the deal that has now been struck in Cyprus turns senior bonds and deposits over €100,000 into contingent capital. Or put another way, uncovered depositors should think of themselves as senior unsecured creditors rather than depositors. And it obviously makes sense to then ask how much funding costs will rise with that risk.
Barclays estimates that across major eurozone countries (with admittedly large variations — 59 per cent uncovered in Italy and 22 per cent in Spain) there are almost €10tn of deposits. Of those, around two thirds are covered by Deposit Guarantee Schemes (i.e. below €100,000) and the rest are not. One of the striking things about that split is that there is currently only a tiny difference in deposit rates between uninsured and insured. Uncovered depositors haven’t felt in any real extra danger. That is likely to change.
The Barclays analysts took a shot at estimating the possible increase in funding costs by extrapolating from the cost of insuring the banks’ bonds — the lower the CDS, the safer the bank and/or its sovereign. From their note:
Having established the CDS of each bank, we then need to convert that into a potential uplift in funding costs for uncovered deposits. We assume that the uplift is 10bps for the quartile 1 banks – in line with the selection of rates we sampled in Figure 9 – and rises by 15bps increments for each subsequent quartile. So a third quartile bank would have an uplift of 40bps (10bps +15bps +15bps) in funding costs on their uncovered deposits.
They got a near six per cent average hit on earnings with a wide range (the final column in the table below takes into account an expanded DGS with more on that below). Even if that is perhaps too harsh, it is still illustrative:
Even if costs stay down, it would be fair to say that European depositors will be much more aware of risk and ready to jump more quickly when trouble appears.
So to the common resolution framework. As the Barclays analysts underline, the recent march of eurozone events has been littered with unpredictable credit events — SNS, IBRC, Cyprus.
Of course there are also instances of credit protection (Monte dei Paschi, Dexia etc) but the danger now lies in a Cypriot direction, so the sooner an actual framework is in place the better.
We’ve put a note on such frameworks in the usual place. In short, if a bank is on the verge of failure, authorities will first try to attempt to recapitalise it by writing down or converting into equity outstanding capital instruments, before applying other resolution tools. If writing down capital securities is insufficient to return the entity to viability, authorities will apply one or more resolution tools, which are: 1) sale of business; 2) bridge institution; 3) asset separation; and 4) bail-in.
Related to that common resolution framework are properly funded European DGS’s — as opposed to a pan-European DGS which isn’t likely to appear soon.
It’s probably worth adding that national DGS schemes are a bit fecked during a real banking crisis… and from that a depressing train of logic threatens. Will return to that idea briefly at the bottom.
For now, back over the Barclays (emphasis ours):
It’s obviously hard to know exactly what the final calibration of the EU DGS will be. The events in Cyprus have in all likelihood increased both the pace at which policymakers will move towards stronger DGS but also potentially the level of the funds themselves. In the absence of any further proposals from Brussels, at this stage perhaps the most reasonable approach is to take the average of the European Parliament’s and Council’s proposals – i.e., the national DGSs will require ex ante funding equal to 1.25% of covered deposits, built up over the next 12.5 years. Co-incidentally, this would bring the EU broadly in line with the Dodd-Frank legislation in the US. On this basis, Figure 28 suggests that EU DGSs would have an aggregate funding shortfall of c€80bn, with nearly three-quarters of this stemming from Germany, France and the UK.
On top of this, the EC proposal is also looking to harmonise and simplify the definition of which deposits are eligible for guarantees. Specifically, the current DGS rules across the EU allow for different countries to include or exclude 14 categories of deposits that can be subject to deposit guarantees. So, for instance, deposits of large companies are excluded from the UK’s DGS but included in France. Under the new proposals, virtually everything will be included except for deposits from financial institutions and from governments. However, when we compare eligibility levels across countries (after adjusting for things like deposits from ‘Other Financial Institutions&rsquo
, the variability is in fact quite small. So harmonising eligibility rules may not make a substantial difference….
Overall, filling the shortfall on the DGS funding could cost banks under our coverage c€34bn. This is equal to around 25% of 2014e PBT – which, if spread out over the next 12.5, years would only amount to around 2% of PBT per annum…
Whilst the impact at a sector level is relatively modest, both Figures 30 and 31 suggest that the bulk of the earnings risk is concentrated in relatively few names. Commerzbank, Sabadell, Credit Agricole, Popular and Lloyds Banking Group all appear the most affected, with an annual earnings drag of between 5-6%. This is driven by a combination of factors, but principally stems from having a low level of existing ex ante funding in domestic DGSs coupled with weak underlying profitability.
There is a suggestion, as part of the common resolution framework, that authorities create a bridge bank as part of a bank resolution process which the banks would have to contribute to. The Barclays analysts suggest banks will face a charge equivalent to one per cent of covered deposits in every EU jurisdiction that they operate in.
Here’s everything in one big table — the potential increase in funding costs for uncovered deposits, the estimated costs of funding national DGS and the proposed bridge bank. Commerzbank makes up the biggest portion of that near $15bn total figure which would take an 11 per cent bite out of aggregate annual profits (click to enlarge):
That’s just an estimate of the direct cost to the banks post-Cyprus and doesn’t take into account higher borrowing costs or increased risk-taking by banks paying out higher rates for example. It’s the net costs that need to be taken into account anyway. If we are overall better off… we are overall better off.
But it’s hard to not worry about this resolution scheme coming into play without a real banking union, including having a pan-European deposit guarantee scheme in place. As economist Paul de Grauwe wrote, the responsibility for the euro-crisis is shared and pushing the risk of bank failures firmly within national borders could backfire badly, precipitating further banking crises.
The way Europeans treated Cyprus suggests sharing the pain isn’t high on the agenda, while as the Economist’s Charlemagne pointed out, Germany has back-pedalled on banking union ever since it was first mooted.
It is possible, as JPMorgan economist Malcolm Barr suggests, that German commitment to banking union isn’t fading and they are maybe looking to shrink the banking system in the periphery. As part of that, they want to push legacy problems in the banking sector back to the host nation to be adjusted. But either way it might be nice to do these things in a different order. Although, that sentence does presuppose an ‘order’ exists…
Related links:
Cyprus crisis to hit European banks hard – FT
How to interpret an ECB press conference: April 4th, annotated highlights – Pawel Morski
Cyprus and the financing of banks – Coppola Comment
Cyprus upends bank capital structure – FT Long Short
