The link between European banks and sovereign risk has weakened following regulation to establish the eurozone’s banking union, according to recently published research by rating agency Scope Ratings.
The eurozone debt crisis was exacerbated by the need to bail out too-big-to-fail banks in the single currency area, which took a heavy toll on the public finances of some of the countries.
Conversely, banks were affected by the weak fiscal position of their home countries, as investors saw them at risk of losses on sovereign bonds on their balances.
The new regulations – the Bank Recovery and Resolution Directive (BRRD) and the Credit Requirements Directive IV (CRD IV) in particular – aim to shift the burden of saving banks that are in trouble from taxpayers to the banks’ creditors and shareholders.
“Now more than ever investors should look at the credit risk of each bank on the basis of its own fundamentals, rather than as a proxy for sovereign risk or, conversely, as being sheltered by its home sovereign,” Marco Troiano, the author of the Scope Ratings report, wrote.
Spain and Italy are seen by many analysts as problem-countries in the eurozone because of their high level of debt. But, Troiano pointed out, their banks’ creditworthiness should be analysed by looking at more than the domestic economies.
In Spain, the banks’ profitability and their diversification offset exposure to the sovereign risk.
“We remain cautious about the high public deficit and debt levels in Spain,” Troiano wrote. Last year, the country’s budget deficit was around 7% of gross domestic public and its public debt is expected to exceed 100% of GDP this year.
Scope Ratings stress-tested Spanish banks Santander and BBVA to check how exposure to Spain’s debt would affect them in the event of possible losses on sovereign debt.
In the case of Santander, exposure to Spanish sovereign risk as of the end of last year was 38 billion euros, two thirds of it in bonds and one third in loans.
This makes up only 3% of Santander’s total assets and 67% of its Core Tier 1 capital base, thanks to the bank’s high degree of diversification, Troiano said.
For BBVA, total exposure to the Spanish sovereign was 53 billion euros, of which 30 billion was in bonds and the rest in loans.
“This exposure amounted to 9% of total group assets or 141% of group Core tier 1 capital base, meaning that the group’s capital ratio sensitivity to sovereign losses is 164 bps for each 10% loss on the sovereign portfolio (excluding tax impacts),” he said.
But he added that BBVA has a strong capacity to absorb losses out of its operating profitability and an “ample, diversified and profitable emerging market franchise.” Both these “more than offset this weakness.”
Over in Italy, both Unicredit and Intesa have significant exposure to Italian sovereign risk. Italy’s debt to GDP is more than 130%, higher than Spain’s, but it is likely to stabilise looking ahead as the budget deficit is lower, Troiano said.
Unicredit’s exposure to Italy is 54 billion euros, representing only 6% of total assets. It mostly consists of bonds, which, Troiano said, can in theory be liquidated faster by secondary sales or by simply not rolling the paper over upon expiration.
“It would take very deep losses to completely eat through Unicredit capital base: for example, we calculate that a 30% loss would take the core tier 1 ratio to 5.8% (excluding tax shields),” he wrote.
“While this is a low level, it is still a reasonable buffer for creditors situated high up in the bank’s capital structure.”
Intesa has significant exposure to Italy’s sovereign risk, with the total at 81 billion euros, representing 13% of total assets and 260% of core capital; 80% of loans granted by Intesa are in Italy, which is by far the bank’s main country of operation.
“As a consequence of the high relative exposure, Intesa’s capital base is very sensitive to potential losses on its domestic sovereign exposure,” Troiano said. “By our calculation, for each 10% of assumed loss, Intesa’s Core Tier 1 Ratio would decline by almost 300 bps.”
Despite the wide variations between the banks’ exposure to sovereign risks, an analysis of their credit default swaps (CDS) over the past five years showed that the financial institutions’ CDSs were tightly correlated with the sovereign CDSs.
This is likely to change in the future, said Troiano, because the correlation between banks and sovereign credit risk will weaken as the various components of the European Banking Union are implemented.
This trend will benefit large, geographically-diversified banks in particular, he added.