In December 2009, the government guarantee schemes for bank bonds that were adopted last autumn will close to new issuance in many EU countries (with guarantees already issued expiring typically in 2012), unless the authorities decide to extend them.1 These schemes were meant to help banks retain access to wholesale funding in the aftermath of Lehman Brothers’ demise, when money and corporate bond markets were severely disrupted.
In this column, we argue that economic and financial conditions are still vulnerable, despite recent improvements, and therefore the EU authorities should extend the guarantees into 2010. Such an extension would act as a precautionary safety net for the banking system. However, when doing so, governments should correct the schemes for some distortionary effects (see Panetta et al., 20092), in particular regarding the pricing mechanism, and accompany them with a credible exit strategy.
Guaranteed bonds proved effective
Since the crisis intensified in September 2008 following the collapse of Lehman Brothers, governments in advanced economies have provided support to banks through both standalone actions directed at individual institutions and system-wide programmes: capital injections to strengthen banks’ capital base, purchases or guarantees of impaired assets to help reduce banks’ exposure to large losses, and explicit guarantees on liabilities to help banks retain access to wholesale funding.
The issuance of guaranteed bonds has been sizeable across regions and provided banks with an important source of funding. As of end-September 2009, close to 1,100 bonds totalling the equivalent of €760 billion had been issued in G10 countries by roughly 180 financial institutions.
Overall, the rescue measures have helped avoid a “worst-case scenario” by reducing the default risk of major banks. Before the interventions, capital markets were not providing sufficient long-term funding to banks; markets were, on net, absorbing resources from banks. The measures implemented since September 2008 have mitigated this anomaly. In particular, the guarantees have allowed banks to refinance maturing bonds, although the intensity of the rollover differs across intermediaries and countries. The portion of overall bank funding guaranteed by governments was initially large, but it sharply declined between the first and the second quarter of 2009 (from 60% to 30%), and it has dropped further in the third quarter.
Extending guarantees into 2010 would put the authorities on the safe side
It may be argued that the current financial environment makes government guarantees unnecessary. Since last March, market conditions have improved sharply and, in many segments, prices returned to pre-Lehman levels. Moreover, the major international banks recorded exceptionally high profits in the second and third quarter of 2009.
Both arguments seem overstated. The rally in financial markets reflects signs of improvement in the conditions of the real economy, which remain fragile – the incipient recovery is heavily policy-dependent, but sooner or later monetary and fiscal stimulus together with financial sector rescue measures will have to be withdrawn. Similarly, the sharp increase in investors’ risk appetite may prove at least in part temporary, as the current wave of optimism may have gone beyond the return to “normal conditions”, after the exceptional wave of pessimism that engulfed markets in early 2009.
As for the rebound in bank profits, it is unlikely to prove a permanent turning point in the sector’s conditions. First, the surge in profitability comes to a large extent from investment banking profits, which are highly volatile. Secondly, the effects of the recession on banks’ loan loss provisions and credit losses have not yet fully emerged; moreover, in the second half of this year, banks’ net interest income will be affected by the zero or even negative growth rate of loans in many countries. Thirdly, bank profits have been inflated by the subsidy implicit in public intervention – central banks have provided banks with very cheap and abundant liquidity and governments’ support measures have benefited banks’ profits and losses. As an example of the latter effect, back-of-the-envelope calculations indicate that for the six largest US banks, the subsidy implicit in government guarantees on bond issuance contributed roughly $1.6 billion to profits in the second quarter of 2009, close to 10% of total profits on average.3 Fourth, the rebound in bank profits may partly reflect one-off valuation gains and reclassifications permitted by the accounting changes recently decided by IASB and FASB. Finally, profitability conditions are extremely heterogeneous across different banks. Recent FDIC data show a dramatically different picture for small- and medium-sized banks, which are more focused than large banks on traditional lending activity (FDIC, 2009). In the second quarter of 2009, FDIC-insured banks recorded losses of almost $4 billion, in a sharp turnaround from the first quarter, when they recorded more than $5 billion profits. The number of so-called “problem banks” has risen sharply.
In conclusion, an extension of the guarantee schemes into 2010 could be seen as providing “insurance” against the risks faced by the financial system. Although stronger banks are increasingly able to borrow without guarantees in wholesale markets, the access to such markets remains difficult for many weaker banks, which continue to depend on government funds. Looking ahead, an extension of the schemes would help to deal with the peak of redemptions of guaranteed bank bonds that is expected in late 2011 or early 2012, assuaging the funding pressures that would otherwise arise.
But the guarantees generated serious distortions…
The guarantees generated a number of undesired side effects and even distortions that need to be taken into account when considering an extension into 2010. First and foremost is the significant tiering of spreads on guaranteed bonds paid by banks from different countries. Banks with the same rating but different nationality have issued guaranteed bonds at different conditions. These differences can be quite large. For example, for guaranteed bonds issued by banks rated A, the range is close to 80 basis points (from 20 basis points for some US banks to 100 basis points for some Spanish banks). In some cases, banks with a better rating have paid much larger spreads than banks with a lower rating.
Empirical analyses (Panetta et al. 2009) suggest that the higher spreads paid by the weakest issuers mainly reflect the characteristics of the sovereign guarantor (such as its rating or the timeliness of payments in case of default of the issuer), whereas bank-specific factors (such as the credit risk of the issuing bank) and issue-specific factors (e.g. the liquidity of the issue) play only a minor role. A breakdown of the spread paid on average by the weakest issuer (160 basis points, see Figure 1) shows that more than half of such spread (90 basis points) reflects the characteristics of the guarantor, while bank-specific factors account for only 30 basis points and the remaining 45 basis points reflect issue-specific factors. This implies that “weak” banks from “strong” countries may have access to cheaper funding than “strong” banks from “weak” countries. Such a pricing of risk does not provide a level playing field for banks and distorts their incentives.
Figure 1. Breakdown of a hypothetical bond spread by contributing factors
Note: Results are derived from a regression analysis on 321 issues. The bar shows how much of the estimated spread can be attributed to country-specific, bank-specific and issue-specific factors. Source: Panetta et al. (2009)
Guarantees also had other undesired effects. First, a large share of the guaranteed bonds were issued by large banks, which have also recorded very large volumes of writedowns. This might suggest that the rescue programmes may have de facto subsidised large and complex financial institutions, which according to some commentators (Roubini and Richardson, 2009) were at the root of the ongoing crisis and may be less likely to use the funds raised to increase lending to the real economy. Second, survey and market information on the investor base of guaranteed bonds in the euro area indicates that a large portion of guaranteed bonds (much larger than for non-guaranteed bank bonds) are bought by domestic investors, in particular banks (see Deutsche Bank, 2009; ECB, 2009; Wall Street Journal, 2009). This may signal that guaranteed bonds are contributing to a partial re-segmentation of the euro area bond market and, as far as the major role of banks among investors is concerned, that these bonds may not be stimulating lending to the real economy but just lending to other banks.
…therefore some adjustments are needed if guarantees are extended into 2010
As already mentioned, it is reasonable to expect that, in the next few weeks, EU governments will extend the guarantee schemes into 2010 in order to provide banks with an “insurance” against funding liquidity risks. When doing so, however, policymakers may wish to take into account the above-mentioned distortions and adopt some corrections to the rescue measures.
First, in order to ensure a level playing field across countries, the pricing of the guarantees on bank bonds could be modified in a way that takes into account country-specific factors. For instance, in the EU “weaker” countries should be allowed to charge lower fees to their banks, in order to offset those large differences in the cost of issuing bonds that are unrelated to banks’ characteristics and give an anti-competitive advantage to issuers from countries with strong public finance conditions.
The second important step is to create the conditions for an exit strategy. Even if it may take some time until conditions for dismantling guarantees are ripe, it is crucial for authorities to have a credible, quick-to-implement exit strategy, in order to prevent banks and other financial institutions from devising their future business strategies on the assumption that they will continue to benefit from government support for an extended period of time, possibly at the expense of their competitors. Another key condition for a successful exit strategy is that funding markets (in particular the market for securitisation, which has not yet recovered from the collapse brought by the financial crisis) resume their normal functioning.
Note: The opinions expressed are those of the authors and do not necessarily reflect those of the Bank of Italy.
1 On 20 October, US authorities announced the end of their Debt Guarantee Programme, expiring on 31 October 2009, and established a six-month “emergency guarantee facility” with more restrictive rules for participation and a much higher fee.
2 Our analysis of the distortions brought about by the Governments guarantee schemes is based on Panetta et al. (2009), which provides an overview of the rescue programmes, comparing their characteristics, magnitudes, and participation rates across countries. The paper also examines the effects of the programmes on banks’ risk and valuation, by looking at the behaviour of CDS premia and stock prices
3 We calculated the subsidy as the difference between the yield at issuance of a guaranteed bond and, on the same day, the secondary market yield of a comparable non-guaranteed bond issued by the same bank.
Deutsche Bank (2009), Fixed Income Weekly, several issues, January to May.
European Central Bank (2009), EU banks’ funding structures and policies, May.
FDIC (2009), Quarterly Banking Profile, August.
Panetta F., Faeh T., Grande G., Ho C., King M., Levy A., Signoretti F. M., Taboga M. and Zaghini A. (2009), “An Assessment of Financial Sector Rescue Programmes”, Bank of Italy Occasional Papers No. 47 and BIS Paper no. 48.
Roubini, N and M Richardson (2009): “There’s virtue in Geithner’s vague bank plan”, The Wall Street Journal, 19 February.
The Wall Street Journal (2009): “Banks dive into government-backed bonds”, 24 March.