The sovereign debt crisis in Europe has been at the epicenter of much public debate. The bottom line is that sovereign debt is not an economic factor that market participants would examine in isolation. It has significant implications for the entire economy, and to the extent these implications touch the banking sector, it has obvious detrimental effects for treasury and finance.
In some of the underdeveloped capital markets within the eurozone, this type of exposure to sovereign debt—called sovereign-bank nexus—often was necessary. Somebody has to buy government bonds, and many countries have traditionally leaned on their banking systems to do exactly that. Once a country’s capital markets develop, with a healthy insurance and pension sector, such as with Australia and Norway, you can increase the pool of buyers. Some countries are definitely not there yet.
Apart from the regulators, the European Central bank also is behind the increase in exposures. For the past few years the ECB has provided banks with cheap loans initially at just 1 percent, recently falling below 0 percent, which they can use to pump into government securities that over the past few years have yielded 7 percent or more. Cash-strapped peripheral banks, many of which have been shut out of primary markets, have welcomed the opportunity to plug capital shortfalls, ploughing over half of their net borrowings from the ECB’s emergency longer-term refinancing operations (LTRO) facility into bonds, while lending a mere 13 percent to the real economy.
This carry trade is estimated to be worth between $5 billion and $20 billion a year to Spanish and Italian banks, with many firms using the trade not only to hide deep losses, but also to build up capital buffers. This is nothing less than a rough manipulation of ECB funds to save private shareholders from ownership dilution.
Amid this growing concern, banks in the eurozone recently crossed a new threshold: They are now more exposed to government debt than at any time since the financial crisis began, with many still increasingly using their balance sheets to prop up ailing governments, deepening the bank-sovereign link that has already pushed a number of countries and lenders into bailouts.
Have lending patterns changed?
Banks in Greece and Italy have been reducing their exposures to their domestic sovereign for several years, but in the 2008, after the Lehman default, they resumed purchases. In 2012-13, banks’ large purchases of government paper crowded out lending to the private sector. With the onset of the crisis the relationship becomes negative indeed in the fiscally weak countries.
What makes European debt crisis unique to any previous experience in the region is that the increased exposure to government financial balance sheet has been coupled with an unprecedented drop in its value.
Although the ECB has stated it is keen to break the sovereign-bank nexus, its practical options are limited. European governments need—and many encourage—their banks to finance growing public debt piles because many simply do not have enough alternative buyers after an exodus of foreign investors. The purpose of banks isn’t to finance their national governments, but they are being encouraged to do precisely that.
Although banks’ exposure to government debt is now lower than in the 1990s, when banks in countries including Belgium and Greece devoted more than 20 percent of their balance sheets to sovereign debt, public debt levels across Europe are much higher today, increasing the risk of a debt restructuring.
Treasury’s next steps
Treasury management in an environment like the one just described, full of uncertainty and turbulence, certainly calls for tough decisions. However, before attempting to answer whether it is time to adopt a more conservative approach when it comes to cash and liquidity management, funding decisions and long-term financial planning, one should bear in mind that where some see a storm coming, others might as easily see the opportunity to strengthen their position in the market against the competition.
Within the next few years, treasury centralization and segregation of operational duties likely will need to be revisited. Centralization cannot be a theoretical construct, but must take into consideration regulation and local conventions that in the case of the eurozone add more complexity to an already complex process. Moreover, outsourcing risk management should be considered, especially for the largest multinational corporations. At the same time, smaller businesses will need to become more sophisticated to remain sustainable in an environment in which the financial markets are no longer able to reliably supply corporate demand for financing.
In the end, treasury and finance groups must take a broader view of risk in light of weaknesses and the recently exposed risks. Treasury is now a strategic function securing liquidity while understanding the true risk profile of the organization. The treasurer now has to be much more involved in the management of the business and ultimately has to become a business leader instead of an administrator.
Christos Chatzidakis is a financial advisor with Farantouris Financial Advisors in Athens, Greece.Read an expanded version of this article in the September issue of Exchange.