Banks slashing sovereign exposure in race to deleverage



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Michael Symonds, Credit Research
Daiwa Capital Markets Europe Limited
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4 November 2011

This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FSA.

That Italian government bond yields continue to march higher should come as no surprise to investors: 120% debt-to-GDP ratio, a government on the brink of collapse and serious doubts over the ability of last week’s “grand plan” to contain the sovereign crisis. But cast an eye over the third-quarter results of European banks and you’ll see another reason why Italian bond prices have continued to slide – there are plenty of eager sellers.

Yesterday, both ING Group and BNP Paribas revealed that they had slashed their sovereign bond portfolios over the third-quarter. Unsurprisingly, most of these reductions were in the debt of Italy (Europe’s largest government bond market), aided by redemptions and ECB purchases, and Greece, the result of increased write downs.

ING reduced its government bond exposure to Spain, Italy, Greece and Portugal by €4.8bn to €6.1bn in third quarter, with Italian holdings cut by €3.9bn to €3.4bn. Meanwhile, BNP reduced its sovereign debt exposure to the euro area programme countries (Greece, Ireland and Portugal) by 38% to €3.3bn in the four months to 30 October 2011, while over the same period exposure to Italy was slashed by two-fifths to €12.2bn. These actions come at a cost. BNP booked €2.3bn in impairments on Greek bonds in Q311 and an additional €362mn in losses from the divestment of other sovereign bonds. The bank also said that continued sales of sovereign debt in October had resulted in a further €450mn earnings hit.

The motivation for European banks to reduce their sovereign exposures was reinforced last week: the recapitalisation exercise currently being undertaken, which determines the solvency requirements of banks after accounting for the recent market valuation of sovereign debt. Decrease your sovereign debt exposure and you reduce the sensitivity of your capital ratio to the volatility of market prices.

The scale of the sovereign deleveraging by European banks over the third-quarter also suggests that the preliminary capital deficit of €106bn identified last week and based on end-June balance sheets could be considerably lower when the shortfalls are finalised later this month reflecting end-September balance sheets (a further quarter of earnings retention, albeit slim, will also somewhat reduce the capital shortfall for profitable banks). But given that the final calculation will also use end-September sovereign bond prices, despite these having moved significantly subsequently, doubts over whether banks’ capital positions are indeed adequate will persist.


Michael Symonds, Credit Analyst

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