Thursday, April 14, 2011

Morning Call: IMF warning: Many European banks on shaky ground

http://seekingalpha.com/news-article/915741-imf-warning-many-european-banks-on-shaky-ground

During our morning calls we spend time analyzing a certain headline and dissecting it.  We addressed the following questions today to the article mentioned above:

1. List three disadvantages that European banks have compare to the US banks.
2. Briefly describe the bailout being done to Greece and Ireland to avoid defaulting on their debts, and being asked by Portugal.
3. What did the European banks do after the last stress test? Or what did they do after Irish banks, who passed the test but failed later?
4. Why does the article state "a source of short-term credit that can dry up rapidly in times of trouble"?  
5. Even after the interest rates were increased 0.25%, they are still at a historically low level. Why the article says small and mid-size European banks "have lost cost-effective access to term-funding markets"?
6. It's being said that the Dodd-Frank Act also put US banks in disadvantages to operate in Europe. What are these disadvantages?


A very brief outline of what each of us stated to the questions above is listed below.  This certainly isn't the complete description of our call:

1. List three disadvantages that European banks have compare to the US banks.

a. Structure: Remaining structural weaknesses and vulnerabilities in the euro area still pose significant downside risks if not addressed comprehensively.
b. Interest rates arisen: ECB key interest rates were arisen by 25 basis points, which reduce the risks as well as banks' profit
c. Need to raise capital: due to the two disadvantage, it's been one of the hardest time for European banks to raise capital to either meet regulation requirements or to acquire source of funds.  

2. Briefly describe the bailout being done to Greece and Ireland to avoid defaulting on their debts, and being asked by Portugal:

Brief summary:

Greece
In May 2010, Greece received a financial rescue from other European countries and the International Monetary Fund of up to €110 billion ($135 billion). The interest for the loans is 5.2%. The government of Greece agreed to impose a fourth and final round of austerity measures.

Ireland
In November 2010, Ireland reached agreement with the IMF and the EU for an emergency bailout package worth €85 billion as a rescue meant to both shore up that nation's banks and confront investor fears. By agreeing to the bailout terms, the Irish government would be given fresh resources to recapitalize its hard-hit banking sector. But in return for the loans, Ireland was forced to pay a relatively hefty 5.8 percent interest rate, higher than the interest charged to Greece for its bailout.

However, according to a report recently published by a former IMF director, when the current IMF-EU deal runs out, Ireland may be unlikely to wrest control of its finances even in 2013 and will be forced to seek a second bailout. (More details: http://www.guardian.co.uk/business/ireland-business-blog-with-lisa-ocarroll/2011/apr/07/ireland-second-bailout-imf)

Portugal
After Greece and Ireland, Portugal became 3rd who asked for financial help from EU. Analysts estimate that Portugal needs around 80 billion Euro to recover from debt crisis. Portugal's troubles differ from Ireland, which pledged to cover huge losses at its banks, and Greece, which lied about its debt. Instead, it had allowed debt to mushroom during a decade in which its economy grew at just 0.7% a year. 

3. What did the European banks do after the last stress test?

The stress tests which took place in July 2010 were largely considered to be too soft. Of the 91 banks in 20 countries which were put through the test, only 7 banks failed the test. Not much was considered to be stressful about these stress tests. The European stress test of 2010 was largely a joke in comparison to the stress test which the United States performed on the U.S. banks. While the European banks were told to raise 3.5 billion euros after the stress test, 10 of the largest U.S. banks were asked to raise $75 billion in capital. This affirms the fact that the European stress test needed to be more strict.

Though investors in 2010 were skeptical at first, the markets reacted positively to the European stress tests. This optimism only lasted a few months and soon after the Irish banks which had passed the stress test needed to be bailed out. Greece and Ireland are going through massive debt issues and thus are unable to shore up funds to support their banking system. The German banks also join the ranks of the Irish and Greek banks and need to acquire more capital from the investors in an effort to keep their doors open.  

4. Why does the article state "a source of short-term credit that can dry up rapidly in times of trouble"?  

Because Supply & demand baby. In bad times, everyone will want ECB's easy and friendly supply of funds which will eventually dry up. 

6. It's being said that the Dodd-Frank Act also put US banks in disadvantages to operate in Europe. What are these disadvantages?

The regulations of the Dodd-Frank Act big European banks to take away business from US banks as across borders these rules do not hold good leading to the disadvantaged US Banks - In brief, analysts claim that European banks can profit from regulation arbitrage opportunities. Some of the reasons being;

1. Regulation of some of the derivatives market
2. Proprietary trading and their investment in hedge funds

One of the key factors is the Volcker Rule that prohibits federal insured banks to trade for their own benefit to prevent them from taking risky bets. This can be a disadvantage to big banks like GS. This rule also prohibits holding more than a 3% stake in hedge funds and private equity. Moreover the Dodd - Frank act requires that the derivatives trading desk be a separate capitalized entity creating regulatory disadvantage.

Also, a recent decision to remove all reference to credit ratings can put the US banks to a disadvantage because this would require them to have higher minimum capital requirements under Basel III. 

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