The Cyprus bailout refocused European risk away from politics back to underlying fundamentals. Over recent weeks, bank spreads have decoupled from sovereign yields - bank credit is trending higher across the Eurozone while sovereign yields are lower across both periphery and core.
We believe these developments are due to market pricing in new risks for the European banks post Cyprus. Since last summer, sovereign yields across the euro area have retracted from previous highs as the introduction of the Outright Monetary Transactions program removed some of the tail risks in Europe.
The banking sector also benefitted substantially from the liquidity operations of the European Central Bank (ECB), through which banks received over EUR 1 trillion of liquidity from the ECB. We believe that we are at a critical point - European banks are not out of the woods yet as their capital structure is still vulnerable.
ECB programs for support of sovereign bonds are not meant to be a backstop for bank credit. Banks still need to deleverage. This process has a few important consequences:
a) On a regional level, the deleveraging process is likely to weigh on growth in Europe. The health of the sovereign will be a key differentiator for the different banking systems, for as long as the national sovereign is the main sector responsible for rescuing banks in trouble.
b) Cyprus still has capital controls in place, but this measure is unlikely to be replicated in case larger countries run into trouble. The feedback loop between sovereigns and banks in Europe hasn't been broken yet. Therefore, we believe that markets pressure can still weigh on either sovereigns or banks in case of sudden deterioration of sentiment. We will need to monitor the characteristics of the loop on a national level.
c) Deleveraging will have implications at bank level as weaker banks will be penalized by the market if they have a debt-heavy balance sheet.
Lessons learned from Nicosia
We believe that the Cyprus bailout provides an indication for the pecking order in future euro area bank recapitalizations.
There is now widespread acceptance in the euro area that loss sharing can happen at all levels of the capital structure. The upcoming European Resolution and Recovery Directive points in the same direction and is now likely to be implemented early.
An important point is that depositors will not be automatically bailed in case a bank is wound down. Depositors would suffer haircuts only if the capital needs of insolvent banks exceed the available reserves and equity plus bondholders' capital (in this order of prioritization).
It moreover seems as if the sovereign will only be impacted after all uninsured bank-level capital has been wiped out, which is in contrast to the EU-IMF bailout of Irish banks in late 2010. The divergence between bank credit and sovereign bond yields will therefore likely continue, as the catalysts have become more bank-specific.
We believe the Cypriot banking system had several unique problems compared with the other European banking systems. We believe the market will differentiate more in the future between the specific fundamentals of European banks based on capital buffers and access to funding.
While the ECB provides the liquidity, banks are responsible for ensuring that their capital is adequate and the credit risk perception is strong enough for the market to maintain their funding. Weaker banks should trade at discounts to better capitalized peers, as risks for bondholders and depositors for weaker banks are now perceived as higher. Some of these banks might also have difficulty to access funding in case the market signals them out for lack of sufficient capital.
Therefore we believe that the choice of bank will be paramount for depositors going forward and that stronger banks will benefit from a "flight to quality" as a validation of their solid balance sheets.
Cesar Perez is chief investment strategist for the Europe, Middle East and Africa (EMEA) unit of J.P. Morgan Private Bank.
© Zawya 2013
