The European Central Bank’s (ECB) plan to slowly withdraw as the major buyer of European sovereign debt will receive its first major test this month during the traditionally busy opening session for corporate and sovereign bond auctions issued by eurozone banks and companies.
The ECB is effectively leaving €500bn (£441bn) of sovereign bonds on the table this year as it winds down quantitative easing, leaving investors to wonder who will take the strain with the biggest buyer now gone. One clear consequence is that sovereign bond prices are falling, and with governments looking nervously at how to roll over significant amounts of debt – Italy, alone, must persuade investors to finance €237bn of its vast debt pile this year – this begs the question whether the continent’s banks will step in, willingly or otherwise, to take up the slack.
The banking discount
The general improvement in the banking market courtesy of rapidly rising interest rates seems to have largely passed the European banks by in 2022. According to research from Berenberg, European banks did well against a backdrop of inflation, recession and an ongoing war in Europe. Berenberg’s analysts reckon that the banks had their earnings upgraded by 15 per cent during the year, as more than three-quarters of listed banks beat expectations for net interest margin, although this only translated into a 3 per cent gain in share prices, outperforming the overall market by a hefty 12 per cent.
This left the sector on a cheap-looking forward price/earnings ratio of under seven. In fact, the discount is now so extreme that the implied cost of capital for banks has risen to 15 per cent. On the four occasions this has happened since 1988, the following year has seen average returns on bank shares of 40 per cent, Berenberg said.
The question is whether these benign conditions will continue with governments needing to find buyers for their debt, while holding banks in their regulatory grip. Could banks be forced to buy governments’ debt instead of giving capital back to shareholders? This might keep some investors awake at night, but the proposition in some ways is false, because one of the unintended consequences of financial regulation in the aftermath of the financial crash in 2008, with the accompanying scandals around Libor fixing, is that banks’ access to sovereign debt auctions was restricted along with their ability to make markets. In other words, if banks are not currently huge buyers of government debt, then it is by regulatory design.
Liquidity rising
It hasn’t helped that the liquidity for AAA-sovereign bonds such as Bunds, or Treasuries, has been relatively low due to central banks buying up available stock. That situation is now reversing and some of the biggest price swings have been seen in normally reliable German Bunds.
With the ECB due to concentrate on buying up debt in southern Europe, there is a clear opportunity for banks to generate income on a base of solid assets. Getting better access will remedy some of the worries over liquidity. Germany’s energy support programmes, plus its rearmament, means that this year will be a record year for issuance, totalling €539bn.
Interestingly, the German government experienced weak demand for Bunds in 2022, possibly for the first time this century, and there are suggestions that changes are needed. One option doing the rounds is for a so-called ‘green shoe’ bidding system where banks can bid for bonds after an auction has closed and buy them at the same price set by the same auction. The aim would be to improve the depth of the market where the assets are themselves highly liquid.
Forcing banks to become primary buyers of government debt would quickly run into problems, again partly due to the regulatory requirement to build up their capital base. In a 2020 paper by Matteo Crosignani, it is highlighted that only low-capitalised banks are generally content to buy government debt because their financial position dictates that linking to the sovereign issuer is a form of safety when they cannot bear too many shocks.
By contrast, better capitalised banks are more likely to lend to the more productive parts of the economy. With European banks now holding average risk-weighted assets of 13.5 per cent, there is little incentive on its own to load up with government bonds. Investors will have a better idea of how the bond auctions are going, including those for corporate bonds, as the month closes out.
