The European Systemic Risk Board is essentially an offshoot of the European Central Bank. And central banks are normally the last to admit that a crisis is around the corner, if not already here.
The European Systemic Risk Board (ESRB), an advisory body set up in the wake of the Global Financial Crisis to monitor the macro-prudential risks bubbling below the surface of Europe’s economy, issued a “general warning” yesterday (Sept. 29) about the financial system. It is apparently the first time the body has taken such a drastic move since its creation in 2010, when Europe was in the maw of the sovereign debt crisis, and it comes just a day after the Bank of England bailed out highly leveraged pension funds.
Given that the ESRB lacks (in Wikipedia’s words) “juridical personality,” it relies on the European Central Bank (ECB) for both hosting and financial support. The board’s members include representatives from the ECB, national central banks and supervisory authorities of EU member states, and the European Commission. And the chairwoman of the board is Christine Lagarde. In other words, it speaks with the full authority of the EU’s two most powerful institutions, the Commission and the ECB.
Crisis Already Here
Another reason this is important is that central banks are normally the last to admit that a crisis is around the corner. In fact, when they finally sound the alarm, it means the damage is already done and the crisis — which they invariably helped create — is already here. In fact, based on the date at the top of the 15-page document (Sept. 22), it seems to have taken the ESRB a full week to get round to publishing the conclusions of its meeting. Which is ironic given the apparent gravity of its findings. Take these two sentences from the opening paragraph:
“[T]he probability of tail-risk scenarios materialising has increased since the beginning of 2022 and has been exacerbated by recent geopolitical developments. Risks to financial stability may materialise simultaneously, thereby interacting with each other and amplifying each other’s impact.”
What isn’t mentioned, of course, is that those recent geopolitical developments include the European Commission’s mind-watering decision to sanction its most important energy provider, which has, all too predictably, eviscerated Europe’s economy. Following the sabotage of Nordstream 1 and Nordstream 2 earlier this week, the EU is almost totally cut off from Russian gas and it doesn’t have an alternative supplier that can remotely fill the void. The price it will pay for this is likely to be fiendishly high, including in the financial sector and markets.
Three Main Risks
The ESRB identifies three main risks to financial stability:
First, the deterioration in the macroeconomic outlook combined with the tightening of financing conditions implies a renewed rise in balance sheet stress for non-financial corporations (NFCs) and households, especially in sectors and Member States that are most affected by rapidly increasing energy prices. These developments weigh on the debt-servicing capacity of NFCs and households.
No great surprise here. As I warned on August 30, in Europe’s Energy Crisis Is Tipping Legions of Small Businesses Over the Edge, energy-intensive companies, particularly small and mid-size ones, are bearing the brunt of the economic pain of Europe’s entirely self-inflicted energy crisis. Many in-person businesses only managed to weather the lockdowns of 2020-21 by taking on huge amounts of debt, which they now have to pay off. Yet that is becoming harder and harder as the price of energy and most everything else soars.
The ESRB’s second risk:
Risks to financial stability stemming from a sharp fall in asset prices remain severe. This has the potential to trigger large mark-to-market losses, which, in turn, may amplify market volatility and cause liquidity strains. In addition, the increase in the level and volatility of energy and commodity prices has generated large margin calls for participants in these markets. This has created liquidity strains for some participants.
Again, nothing new here. As Yves noted in early September, in Lehman Event” Looms For Europe As Energy Companies Face $1.5 Trillion in Margin Calls, “we are beginning to see, as in 2007 and 2008, that market time moves faster than both real economy and political time, and that has consequences.”
Those consequences include untimely margin calls on energy bets gone bad. As Yves noted in her piece, “It will be some time before the press can ferret out how much of this [is] due to sensible hedges gone bad, stupid hedges gone bad, and speculation gone bad.”
Now for ERSB’s risk number three (comment in parenthesis my own):
The deterioration in macroeconomic prospects weighs on asset quality and the profitability
outlook of credit institutions. While the European banking sector as a whole is well capitalised, a pronounced deterioration in the macroeconomic outlook would imply a renewed increase in credit risk at a time when some credit institutions are still in the process of working out COVID-19 pandemic-related asset quality problems. The resilience of credit institutions is also affected by structural factors, including overcapacity, competition from new providers of financial services as well as exposure to cyber and climate risks.
Note the mention of “overcapacity,” one of the ECB’s biggest bugbears. For the central bank, Europe has too many small banks, as opposed to too many banks that are simply too big to exist.
Weak Links Lurking Within System
The ESRB may assert that the European banking sector is reasonably well capitalised as a whole, (which is debatable), but that doesn’t mean all of Europe’s systemic and non-systemic mid-size banks are well capitalized. Many weak links continue to lurk within the system. Serious questions still remain about the health of Deutsche Bank, Germany’s sole globally systemically important bank (G-SIB). As a VoxEU article cross-posted here back in 2014 pointed out, many of Europe’s biggest banks — particularly in France and the UK (which was still in the EU at that time) — are not just too big to fail; they are too big to bail.
What about Italy’s banks? Well, there’s good news and bad. The good new is that Italy’s non-performing loans (NPL) ratio is currently at its lowest level since the Global Financial Crisis. The bad news is that this is largely due to the mass-securitization of Italian banks’ huge trove of toxic loans. As previously reported, over the past five or so years, Italian banks, with help from Wall Street’s finest, have been slicing, dicing, and repackaging non-performing financial assets, such as loans, residential or commercial mortgages, or other sometimes uncollateralized Italian “sofferenze” (bad debt) into asset-backed instruments which can then be sold to yield-starved gullible investors all over the world.
In other words, Italian banks’ toxic debt has been spread far and wide across the global financial system. And a large part of it is guaranteed by the Italian state, which means that when the firms that bought the debt begin discovering that it is unrecoverable, which is happening already, the Italian government will be left holding the tab. That tab is already pretty full, given the Italian government has a public debt-to-GDP ratio of over 150%. That’s not to mention the €277 billion of fresh corporate debt that Italy underwrote during the pandemic.
Most other governments in Southern Europe are in only marginally better fiscal shape following the virus crisis, while Greece has a debt to GDP ratio of 190%. But the problems are not just in the South. The debt-to-GDP ratios of France and Belgium are also well above 100%. The debt-to-GDP ratio for the Euro Area as a whole crossed the 100% threshold for the first time last year and is still dangerously high, at 96%. Which is probably why sovereign debt remains an “elevated systemic risk”, warns the ESRB:
“The slowdown in economic growth and the tightening of financial conditions are weighing on medium-term sovereign debt dynamics. High public indebtedness remains one of the main macroeconomic vulnerabilities in several Member States.”
Here are some other “elevated systemic risks” the ESRB flags up:
- Vulnerabilities in the residential real estate sector, as rising mortgage rates and declining real incomes reduce households’ capacity to service their mortgages.
- The commercial real estate (CRE) sector also faces “rising challenges”, as a result of higher financing costs and construction prices, bottlenecks in the supply of construction materials and structural trends such as lower demand for office space. “Given that profit margins in the EU’s CRE sector are already low, these developments could render some existing or planned CRE investment projects non-profitable, increasing default
risks and compounding concerns about CRE-related non-performing loans, which are already high and rising.” - “Cyber incidents” resulting from the war in Ukraine, which may “disrupt critical economic and financial infrastructures, and impair the provision of key economic and financial services.” This echoes similar warnings issued by the intelligence services of the “Five Eye” nations (US, UK, Canada, Australia, and New Zealand), the Reserve Bank of Australia and the World Economic Forum.
To “contain these risks and mitigate their impact,” (ha!), the ESRB calls on “relevant authorities” (i.e., central banks) to “avail themselves of the full range of micro- and macroprudential tools”. And if that’s not enough, the relevant authorities may need to “make use of their supervisory powers to mitigate risks to financial stability and ensure that markets do not become impaired.” Which essentially means bailouts and bail-ins.
Of course, close cooperation between relevant authorities will “enhance the efficiency and effectiveness of policy responses.” At this point it’s worth recalling that the Euro Area never quite got round to instituting a bloc-wide deposit guarantee fund, mainly due to fierce (and to some extent, understandable) opposition from Germany and other core economies. According to an IMF paper from January, the European Union continues to be “challenged by banks that are too small for resolution and too large for liquidation.” Not exactly comforting.
Derivatives Still a Systemic Problem
The ESRB also urges credit institutions to ensure that their provisioning practices and capital planning properly “account for expected and unexpected losses that may be caused by the deterioration in the risk environment”. Banks should also “ensure good visibility of their nearterm liquidity risks and concrete contingency plans to tackle these risks,” instead of hiding them as far off their balance sheets as possible.
The ESRB’s “general warning” comes just a day after the Bank of England had to bail out the UK’s bond market. Once again, derivatives were a large part of the problem. In this case, interest rate swaps had triggered a doom-loop of accelerating bond sell-offs that came close to unravelling the 2.1 trillion-pound gilt market. As the yields on UK gilts spiked on Monday and Tuesday, pension funds that had loaded up on interest rate swaps suddenly faced margin calls they could not meet — at least not without selling off large holdings of UK bonds which put even further upward pressure on bond yields. Rinse. Repeat.
Analysts at Jeffries told Morning Star yesterday:
“In a scenario where rates are rising, a fund backed entirely by gilts would be under no pressure to change anything. However, where derivatives are used, the losses created by the derivatives prompt calls for additional margin or the fund runs the risk of its positions being stopped out.”
In the end, the Bank of England intervened by pledging to buy huge volumes of UK bonds over the next two weeks, thereby putting an end to its quantitative tightening program before it had even begun. Meanwhile, the spreads on US dollar swaps are blowing out to their highest levels since 2011, when the Fed announced coordinated central bank plans to boost liquidity by lowering interest rates on dollar swap lines. In other words, derivatives are doing exactly what they did during the GFC: magnifying risk and extending contagion.
