Core Capital of French Banks - Is There a Health Concern? November 23, 2011 The content of this article was provided by Spectrum Asset Management, Inc., an affiliate of Principal Global Investors®.
Spectrum is a leading manager of institutional and retail preferred securities portfolios.
The implementation and scope of the European Financial Stability Facility (EFSF) will have a material impact on sovereign debt valuations and European bank capital.
This note provides an analysis of the French banking sector and an opinion on the investment merits from a sovereign debt capital exposure perspective. The EFSF has a total guaranteed commitment of €726 billion, sufficient to obtain a triple-A rating from Moody's, S&P and Fitch, and an actual lending capacity of €440 billion. The facility has committed about €174 billion to Greece, Ireland and Portugal which leaves about €266 of uncommitted resources, according to Moody's.
The periphery sovereign debt contagion now has Italy in its crosshair. The Italian sovereign bond market is the third largest bond market (€1.2 trillion) in the world, though its rise is underpinned by a precarious economy. Italy is responsible for its 19% share (based on membership in the euro currency union) of the EFSF - this equates to about €140 billion. Consequently, the net €266 billion of uncommitted EFSF resource could decline to €126 billion if Italy cannot stand up to its guarantee commitments (by succumbing to a bailout). We assume that this €126 billion of "net shadow support" available through the EFSF is a worst case outcome for the facility.
Importantly, there is a wider safety net available to the European currency union than the €440 billion of gross capacity from the EFSF alone -- two other sources provide another €310 billion. They are comprised of: 1) €60 billion from the European Financial Stabilization Mechanism (EFSM), and 2) €250 billion from the International Monetary Fund (IMF). The sum of these three sources brings the total support capacity to €750 billion - of this gross resource, the uncommitted capacity to date equals €449 billion. An Italian default would cause the EFSF component to decline by €140 billion; therefore, an adjusted uncommitted capacity would be €309 billion if Italy were need support.
It is this adjusted uncommitted capacity amount that is relevant to European bank capital support if Italy's sovereign credit were to require a bailout. One cannot determine exactly if or when Italy would weaken to that extent, but let's look at an arbitrary corrective measure in order to build a conservative scenario. As the general public debt-to-GDP (GPD/GDP) ratio of the two strongest members (i.e., Germany and France) is 83%, we can make a similar assumption to adjust Italian sovereign debt down to that same ratio.
World Bank reports Italy's 2010 GDP as €1.5 trillion; Eurostat reports Italy's 2010 GPD/GDP at 118%; form this we estimate Italy's 2010 general public debt to be €1.8 trillion. Italy's sovereign bond market's share of this general public debt is 67% (€1.2 trillion /€1.8 trillion). We then apply the 83% target adjustment on the €1.5 trillion GDP which knocks down Italy's total public debt to a target of €1.25 trillion - this adjustment would require a €550 billion (€1.8 trillion - €1.25 trillion) haircut that could be voluntarily exercised (specifically) on Italy's €1.2 trillion sovereign bond market. This equates to a 46% haircut on Italy's sovereign debt and would leave €650 billion of Italian sovereign debt needing to be repaid and/or refinanced through conventional fiscal means (e.g., through fiscal and political reforms). Any haircuts would be trimmed off of bank Tier-1 capital, which is largely why the Eurozone hybrid and common equity markets are under pressure. Haircuts are losses so the question becomes, is the €309 billion of uncommitted funds sufficient to save the currency union? We believe that it can be, provided that the European Central Bank (ECB) continues to provide liquidity to the system as it has been and that economies reform.
Comparing Greece to Italy can be like mixing oil with vinegar. Italy is a functioning economy that can benefit from a productive and collectable a tax base where Greece is dysfunctional. This leads us to conclude that Italy would not require haircuts to the same degree as Greece in order to secure interim funding. Nonetheless, we postulate that to the extent an aggregate 46% haircut on all European periphery sovereign debt were to become an eventual reality; the banking system of France can survive. It is important to remember that capital flows only to those that have funding; funding begets capital and capital begets funding - the going concern needs this combination of capital (heart) and liquidity (blood).
The European Central Bank needs to maintain its role as the defibrillator by supplying the shock (and awe) that beats the heart that distributes the blood. Basel-3 determines the size of a bank's heart by Tier-1 and Core Tier-1 Equity (CT1E) measures; it requires 6% Tier-1 and 4.5% CT1E to be posted by 2015. But the markets have shaken policy makers into demanding 9% CT1E or 2x the Basel-3 mandate - and the market wants surgery now! Banks (and even regulators) on the other hand, want to improve the system's health through changing operating habits in order to improve health though more organic means rather than through quick (and perhaps even unnecessary) surgery.
The markets are (again) suffering through periods of heart palpitations which are becoming more and more normal within the context of the Eurozone fatigue. We view other people's nervousness about near term fitness as potential longer term buying opportunities of healthy hybrids - notably, the French banks. We assume that a 46% aggregate haircut on periphery sovereign debt is as bad as bad should be for the Eurozone periphery (which would put Italy at fiscal parity with France and Germany) given the scope of existing monetary commitments and the political will to preserve the monetary union.
Therefore, if the four big French banks (i.e., BNP, SocGen, Credit Ag and BPCE) were to write down their exposures to Greece, Ireland, Italy, Portugal and Spain by 46%, for example, aggregate Core Tier-1 Equity would decline by €39 billion euro (instantly) for the group; CT1E would decline from 9.1% to 5.0% yet still be above the horizon line 4.5% minimum set by Basel-3. Moreover, these banks would still have four full years to accumulate capital in excess of what would already be sufficiently above the 4.5% minimum - therefore, knowing that a 7% CTE1 objective in 2019 is the Basel-3 total health objective (which includes the Conservation Buffer), the French banks would need to accumulate 1.4x (i.e., 7%/5%) that of the post write-down amount in order to satisfy the complete objective. Translating this 8 year accumulation allowance into an annual return-on-equity requirement to meet the 7% CT1E objective, means that French banks would need (only) 40% of a doubling time to earn in (and retain) equity through operations. The following table illustrates some ROE possibilities and each one's implication on the group's meeting the Basel-3 CTE1 objective after the write-down scenario:
We conclude that the Basel-3 initiatives for Core Tier-1 Equity capital are quite attainable for French banks to be heart healthy. Further, the above table adds clarity on why the French regulator has stated that its banks are adequately capitalized as they are on plan to be ahead of schedule in all cases after our stress test. Importantly, the big four French banks (i.e., BNP, SocGen, Credit Ag and BPCE) are in a fit capital position going into the adjustment which should aid them in adroitly managing sovereign risks with flexibility. This flexibility can come through not only tapping public markets for core capital, but also through tactical liability management exercises (already underway). Supportive forecasts for internal capital generation that appear reasonable and probable form the basis of our constructive long term health assessment of the French banks.
The group's potential capital needs under our stress test (€39 billion) are covered by the "net shadow support" of the EFSF (€126 billion) by 3.2X -- this public support would only be needed if the banks were to have no public access to equity (unlikely). Indeed, it seems counter-productive for any bank that has funding access and that even meets its "Conservation Buffers" ahead of schedule to be treated harshly by its regulators. Therefore, we view the risk of dividend passes on French bank hybrids in order to meet prospective capital objectives as improbable.
A positive assessment of French bank health notwithstanding, the overall broad market structure is likely to foster continued volatility (please see our 3Q11 quarterly report). We continues to have a BUY rating on selected French banks; BNP, SocGen, Credit Ag and BPCE. Our total rate-of-return sights are on the stable long run capital horizon which should help to reduce any nausea caused by only looking down at the immediate rough seas of uncertainty. Importantly, this market nausea is more likely to be created by sea sickness rather than by coronary illness.
PRINCIPAL GLOBAL INVESTORS | 2 | CORE CAPITAL OF FRENCH BANKS
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