| European banks: who needs a ‘bad bank’? |
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| A research report ‘European Banks: Who Needs a ‘Bad Bank’? Part 2’ by Priyanka Malhotra & Roberto Henriques of J.P. Morgan Securities suggests an alternative to the 'bad bank' model as a solution for Europe's banks. They propose an asset protection scheme where risk of the banks' 'toxic' positions are effectively transferred to the Government in return for a fee. |
Asset protection may lead to lower risk-weightings
We think that the asset protection scheme in addition to removing the market risk for the banks holding the ‘toxic’ assets will allow for a potential reduction in risk weighted assets which will be supportive of higher capital ratios. The reduction in risk weightings should work given that the bank sourcing protection from the Government should be able to replace the existing risk weighting of the assets with the risk weighting of the entity providing the protection assuming the standard treatment of CDS sourced protection. We also note that under these circumstances, the bank benefits in terms of risk weightings by the reclassification of risk with a triple A sovereign having a vastly different set of parameters (Loss Give Default, Probability of Default) to that of a triple A corporate.
Additionally, the asset protection scheme is likely to provide greater comfort to investors given that the risk transfer is very transparent and clean, thus allowing investors to have greater comfort with the financial condition of the bank. While most of the investor attention has been focused on the quality of the marks on books of ‘toxic’ assets which banks have on balance sheet, with the risk transfer to the government, such concerns should become academic for credit investors (but likely to be important for investors in sovereign debt!). Banks still retain some exposure to upside. One of the concerns that banks might have with regard to some of the asset transfers is that some of the economic upside would be transferred to a ‘Bad Bank’ and in the case of a miraculous recovery of these assets the banks might have sold at the bottom of the market. This might especially be the case for assets where the current distressed valuations are more reflective of the current unfavorable technical scenario (many sellers, no buyers) rather than ultimate expected loss with these assets. Hence the asset protection scheme offer the optimal risk profile for the banks involved given that they pass on losses to the government and retain any potential upside in the valuation of these instruments.
Nationalisation of the sector is avoided
Direct cash injections into the European banks are another alternative to the ‘Bad Bank’ approach in that they directly address the markets concerns of solvency and theoretically allow the banks to address more realistic valuations for their ‘toxic’ assets. However the major concern under this approach is that direct capital injections tend to increase the participation of the government in the banking sector with outright nationalisation being the ultimate end-game. However, governments are increasingly more reluctant to go down this route, given that both the capital injections which need to be funded and ultimately the nationalisation of a bank will lead to a general undermining of public finances. Hence, we believe the asset protection scheme is a good alternative given that with the risk transfer of ‘toxic’ assets, the bank’s P&L and capital base is no longer impacted by the downside risk of these positions.
In short, the asset protection scheme is a recapitalisation by stealth. We also think that the injection of capital has some disadvantages relative to the asset protection scheme from the investor perspective. To this extent we note that even for banks which have been on the receiving end of various rounds of recapitalisation, that market still remains relatively concerned about the eventual true scale of the losses and hence the recapitalisation efforts have partially failed because they have not boosted market confidence in the affected bank. Furthermore, the fact that banks may have to be provided with capital infusions undermine market confidence given that ultimately the nationalisation of the bank may be done on terms which are less than investor friendly. |
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