European Central Bank ‘should follow US lead with TARP’

bank stress test

While a long-term refinancing operation and quantitative easing (QE) have solved the European banking sector’s liquidity problems over the past five years, the elevated amount of non-performing loans still sitting on many banks’ balance sheets is still a major challenge, notes asset management firm GAM.

Whether European leaders can reach an agreement on how to address this issue remains crucial, says Davide Marchesin, fund manager in GAM’s non-directional equity team. In the current environment, the best placed banks have solid credit quality, a high level of shareholder equity and a high return on assets, enabling them to absorb increased credit costs.

GAM believes the most effective solution for restoring confidence in more vulnerable banks would be for the European Central Bank (ECB) to follow the approach taken by the US Federal Reserve to shore up the damage caused by the subprime crisis.

In 2008, US Congress signed the Troubled Asset Relief Program (TARP), allowing the US Department of the Treasury to purchase or insure billions of troubled assets. The Treasury then purchased illiquid, difficult-to-value assets from banks and other financial institutions and the Fed expanded its balance sheet from approximately US$500bn of assets at the end of 2008 to more than US$4000bn by the end of 2014. This included more than US$1500bn non-government papers, such as residential mortgage backed securities (RMBS).

Currently, European governments cannot fill in bank capital holes and the ECB is not permitted to buy troubled assets from banks, just AAA paper. By allowing the ECB to buy banks’ troubled assets and plug the capital shortfalls that would eventually arise, credibility would be restored. Until then, European banks will remain under a lot of pressure.

Commenting on Italian banks, GAM notes that Italy’s economic growth over the past 10 years has been at weak, with periods of recession. This, coupled with the financial crisis and some specific cases of mismanagement, caused a sharp increase in non-performing loans (NPLs). The source of such problematic assets is widespread and includes commercial real estate, small and medium enterprises (SMEs) and consumer loans.

Italian banks continue to hold these troubled assets because in recent years, they have been forced to increase their coverage ratios and simultaneously improve their capital positions. Now that, on average, such assets are written-down to 40 cents, they could eventually sell them at 25-30 cents without incurring unbearable losses.

“We believe that a stress test would highlight an overall solid capital position for Italian banks, but also some risks, namely high Texas ratios (amount of gross NPLs on shareholders’ equity plus reserves). A consistent disposal of such assets will be required to address this,” says GAM.

“We don’t see any Italian bank eager to step-in and buy the weakest players. The restructuring and clean-up process will thereby need to be managed and organised directly by the Italian government, with the full support of European institutions. If they manage to find a credible solution for Banca Monte dei Paschi before the October/November referendum, this could turn into a material positive trigger, not just for Italian banks but for the European banking system as a whole.”

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