Dexia’s demise leaves more questions for banks
There are scores of financial institutions for whom
wholesale funding markets are shut and who would be bust were it
not for the European Central Bank pumping billions of unlimited
liquidity into the system.”The short-term funding issue faced by Dexia was not so much
related to ECB repo operations but repo agreements with other
banks,” said Satish Pulle, senior investment analyst at European
Credit Management.Bankers and investors say Dexia faced a unique combination
of specific factors: an out of date business model - not least
an over-reliance on wholesale funding - large exposures to
high-risk euro zone sovereigns, a rapid deterioration in market
risk of its derivatives portfolio and credit downgrades.”When a bank has a lot of derivatives contracts outstanding,
and the bank’s credit quality deteriorates, counterparties may
demand more collateral. This, added to sovereign and
sub-sovereign exposures, seem to have made Dexia’s position
difficult. Whether this is the specific cause, it’s difficult to
know,” said Pulle.”Whether other banks will run into similar problems as
Dexia, it’s difficult to know,” said Pulle. “But it is safe to
assume that as bond prices fall and CDS positions change, banks
will need to post more collateral and other weaknesses in the
system might get exposed.”According to CreditSights, while the bank had EUR88bn of
assets eligible for ECB repo operations, only EUR20bn of these
were unencumbered at the end of June. Furthermore, while the
bank had reduced its dependence on short-term funding, it was
still EUR96bn at the end of June, with EUR34bn of ECB financing,
EUR37bn of repos and EUR25bn of unsecured funding.ANOTHER NAIL IN THE COFFINThe next nail in Dexia’s coffin was the collapse of
short-term debt markets. When money market investors and bank
counterparties started, respectively, to reduce exposure and
pull credit lines, the game was up.In this volatile market environment risk managers at Dexia’s
counterparties would have taken a very careful look at swap and
repo credit lines, with a view to limiting their exposures to
perceived risky names.”Like Depfa, Dexia was lending long and swapping it back to
floating,” said a FIG banker. “The problem is, their swap
position went against them, which led to more collateral demands
and that is why they ended up running out of liquidity.”Rating downgrades can also be a catalyst that pushes banks
over the edge. Dexia’s chief executive, Pierre Mariani, talked
of a self-fulfilling prophecy when Moody’s said it was putting
the bank’s main operating entities on review for downgrade
because of worsening funding conditions.BASEL ARBITRAGEDespite boasting a Tier 1 ratio of 11.4%, versus 10.6% at
the end of 2008, Dexia was insolvent. Why? The bank’s
explanation states the legacy portfolio was impacting the group
structurally despite its supposed good quality - in other words
returns were insufficient to justify the increased cost of
financing.The only other bank that had Dexia’s business model of
specialising in long-dated lending to the public sector is the
now-defunct Depfa.Of course, because Dexia’s huge balance sheet was stuffed
with low-margin but zero risk-weighted assets its capital ratios
looked fantastic, but when public sector finances deteriorated
the real capital position was somewhat different.UNLOVED, NOT SAVEDThe swap moves and counterparties’ concerns hit Dexia’s
liquidity dramatically. The bank was struggling to borrow to
finance its positions and using clearing houses or the ECB was
clearly not possible.Providing unsecured funds via Emergency Liquidity Assistance
is complicated by it being underwritten by individual national
central banks rather than the ECB, and Dexia was clearly not
considered a national champion in France, while its size would
have been problematic for Belgium.While identifying the next victim is difficult because of
the nature of the crisis and uniqueness of Dexia, market
participants have little doubt that Dexia will not be the only
bank that needs to be rescued.”It is likely that we will see more wind-downs going
forward,” said Alberto Gallo, senior European credit strategist
at RBS.”Some bad banks simply cannot be recapitalised forever. For
example, the banks that scrapped or failed the stress test may
not be sustainable.”Five Spanish banks, two Greek banks and one Austrian bank
failed the European Banking Authority’s stress tests in July
this year. Another 16 banks with capital ratios between 5% and
6% under the EBA’s adverse scenario barely passed.Gallo added that the size of European banks’ assets, which
at EUR25tn (excluding Cajas and German bad banks) equal twice
Europe’s GDP, meant that governments could not bear the full
weight.”If you look at the second tier banks that are
undercapitalised or the banks where the business model is under
pressure, such as the wholesale funded ones, then we can expect
to see more de-leveraging and wind-downs.”
