News Analysis: Pain Builds in Europe’s Sovereign Debt Risk

LONDON — European banks for years bolstered their balance sheets with assets considered safe and secure: the sovereign debt of European countries.

But now this debt no longer appears so safe, weakening banks when countries still depend on them for loans to help finance their gaping budget deficits.

The results of the latest European bank stress test, released on Friday, revealed in greater detail than was previously known just how exposed Europe’s banks are to the government bonds of Greece, Portugal, Spain and Italy, which are losing more value daily.

Only eight small banks in Spain, Greece and Austria failed the European Banking Authority’s test, and were ordered to increase their reserves to protect against possible losses. But this may turn out to be a sideshow.

While the tests were criticized for not factoring in a Greek default, the more immediate concern could be the effect on bank balance sheets as their sovereign bond holdings — especially in the case of widely held Italian debt — continue to lose value in the bond market sell-off.

With those bonds now worth less, calls are growing for Europe to take urgent action to recapitalize its banks, as the United States and Britain did in 2008 when the financial crisis damaged the balance sheets of their banks. At the same time, the problems of Europe’s banks also mean it will be difficult for the spendthrift faction of European nations to rely on them to borrow aggressively to finance budget deficits, largely with impunity, as they did until 2008.

The prospect that the flu will spread beyond Greece and Spain to infect Italy and perhaps even France and Belgium, is sure to be a point of urgent discussion on Thursday in Brussels at the debt summit meeting for European Union leaders.

The exposure of European banks to sovereign debt is a point that regulators have long underscored, most recently and acutely in an illuminating report issued this month by the Bank for International Settlements.

The report highlighted just how thin the capital buffers are for banks in highly indebted European nations. For example, banking systems in Belgium, Greece and Italy are sitting on local government bond holdings that range from 60 percent to 90 percent of total bank capital.

“Until recently, investors have paid little attention to diversifying their portfolios of government bonds of advanced countries, as these bonds were considered virtually riskless,” the report warned. “This situation has changed: some sovereign securities have already lost their risk-free status, while others may do so in the future,” it said. Take Greece, for instance. The National Bank of Greece passed its test with a Tier 1 capital ratio of 11 percent, compared with a minimum of 5 percent required to pass. But the bank holds 18 billion euros worth of Greek bonds that are, at best, worth half that amount, and if written down accordingly would immediately wipe out the bank’s capital of 8.1 billion euros. 

BNP Paribas in France and Commerzbank in Germany also passed, but they own 5 billion and 3 billion euros, respectively, in Greek bonds. (As is the case with most banks, these assets are held in the banking book, not the trading book, so they do not reflect the true market value until written down.)

But it is to Italy, which, with its huge debt financing burden, is home to the world’s third largest bond market after Japan and the United States, that Europe’s banks remain most heavily exposed. 

It was the Greek finance minister who zeroed in on this point last week. Yes, Greece’s debt is high at 355 billion euros, Evangelos Venizelos said in a speech to his Parliament. But it was not as dire as Italy’s, he argued, because Italy borrows about that amount in a single year to keep current on its own financial obligations, which at 120 percent of gross domestic product are second only to those of Greece itself.

Again BNP Paribas stands out in that regard, owning 28 billion euros in Italian bonds (just about half its core capital at the end of 2010). Other big holders of Italian bonds include Commerzbank with 11 billion euros and Crédit Agricole in France with 10.7 billion euros.

Unicredit, the large Italy-based bank with significant operations outside its core market, remains tied to the fortunes of its home country. At 49 billion euros, its Italian government bond holdings are 140 percent of capital as of 2010, according to stress test data.

Italian government debt does not carry anywhere close to the risk of its Greek counterpart. Italy’s budget deficit of 4 percent of gross domestic product puts it in a different category, and there has been no talk of Italy’s not being in a position to keep paying its obligations.

But as foreign and domestic holders of Italian bonds keep selling their holdings — bankers remark that many of the sellers are weak holders who were attracted to the higher yield but never thought that Italy would be lumped with Greece and others —  the price of the benchmark Italian bond has plummeted and the yield has spiked. 

What was once seen as more or less a risk-free asset is becoming increasingly less so, as the Bank for International Settlements’ report notes.

Beyond the sovereign debt question, other revelations are to be found in the individual bank disclosures.

The British banking giant Barclays, for example, has significant exposure to the troubled Spanish economy. After its home country and the United States, Spain represents the third largest credit market for Barclays. (Of this 43.9 billion euros, close to half is loans to Spain’s devastated mortgage and commercial real estate sectors.) 

And the British-government controlled Royal Bank of Scotland has 64 billion euros of dubious Irish loans on its books (12 billion euros of which is already in default), compared with a capital level of 58 billion euros at the end of 2010.

For now, all these banks can say that they have passed Europe’s latest banking crucible. Many have also raised equity over the last year to address market concerns.

But as the crisis worsens, it may well be the case that today’s capital cushion will not be enough to cover tomorrow’s sovereign bond losses.  

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