By Simon Kennedy Nov. 30 (Bloomberg) — European Central Bank President Jean-Claude Trichet will shine a light on the weakest European banks when he begins withdrawing the cheap loans that propped up the financial industry this year. Dexia SA and Commerzbank AG got a taste of what may come when their shares sank as much as 3.7 percent on Nov. 20 as Trichet explained the need to slow the unprecedented flow of money and tightened collateral rules. He may go further Dec. 3 in disclosing just how the ECB proposes to wean the euro-area’s lenders off emergency aid. Less liquidity will show “the fundamental quality of different banks,” said Elie Darwish , an analyst at Exane BNP Paribas in Paris, who has an “underperform” rating on bank stocks and recommends clients sell shares of Dexia . “They benefited very much from the favorable environment created by the ECB so may be hampered by the unwinding of this.” Government-backed lenders, including Frankfurt-based Commerzbank and Dexia in Brussels, will have higher funding expenses, according to Simon Maughan , an analyst at MF Global Securities Ltd. in London. He ranks Commerzbank, Germany’s second-biggest lender, as the worst performer next year of the bank shares he follows. The nations with the euro area’s biggest budget deficits, including Ireland and Greece, also face rising borrowing costs after benefiting when banks recycled the ECB’s money into their bonds. The cost of insuring $10 million of government debt against default for five years jumped about 50 percent this month for Greece and 23 percent for Ireland. ‘Swimming Naked’ “As Warren Buffett has observed, it’s when the liquidity dries up that you’ll see who’s swimming naked,” said Erik Nielsen , Goldman Sachs Group Inc.’s chief European economist in London. The ECB may end up “tightening by stealth” if its removal of support pushes up the interest rates charged by banks and in money markets, even as Trichet signals that isn’t his intention, Nielsen said. The threat of side effects demonstrates the difficulties ahead for the ECB as it seeks to cut stimulus programs, especially in an economy whose 16 nations are recovering at different speeds. That’s prompting Trichet to promise a “gradual” withdrawal. “A great theme will be unintended consequences,” said Fred Goodwin , executive director of rates at Nomura International Plc in London, who predicts an increase in banks’ credit risk as measured by the Euribor-OIS spread. “There will be a link between tighter liquidity and bank risk that will show up in stock prices, credit-default swaps and borrowing costs.” Without Stimulus The 64-company Bloomberg Europe Banks and Financial Services Index returned about 40 percent this year. The concern for investors is, “absent stimulus, how much growth is there in the sector?” said Jonathan Tyce , an analyst at FBR Capital Markets in London. Maughan has an average growth target for bank stocks of as much as 25 percent next year and says two-thirds are “out of the woods.” A “quality differentiation” exists, with investors demanding higher borrowing costs when lending to companies that have government aid such as Commerzbank, Dexia and Dublin-based Allied Irish Banks Plc , he said. The reliance of some lenders on the central bank is “probably the issue causing the greatest concern now,” Maughan said in a Bloomberg Television interview on Nov. 25. “What is going to happen to your funding costs when you have to go back to private markets and pay a proper price for your debt?” Selling Commerzbank Seventy percent of analysts recommend selling Commerzbank shares and 41 percent advise selling those of Dexia, according to data compiled by Bloomberg during the past three months. By contrast, 20 percent suggest selling Deutsche Bank AG , Germany’s largest bank. Deutsche Bank , which Maughan lists as the best performer in its group in the euro-zone next year, has an annualized return on equity of 16 percent, compared with Commerzbank’s 0.02 percent and Dexia’s 12.8 percent, Bloomberg data show. BNP Paribas SA and Societe Generale SA , France’s biggest banks by market value, repaid government aid provided during the crisis, giving them an advantage. BNP Paribas said last month investors sought 2.5 times the stock offered in a 4.3 billion- euro share sale to reimburse the state. Societe Generale paid back 3.4 billion euros this month. Just 3 percent of analysts have a “sell” rating on BNP Paribas , and 16 percent have that view of Societe Generale. Both companies are based in Paris. Commerzbank spokesman Reiner Rossmann declined to comment on the implications for the lender of the ECB’s strategy. Officials at Dexia also declined to comment. Bad-Debt Forecast Commerzbank said Nov. 5 it expects a “difficult” fourth quarter, predicting loan-loss provisions will rise to about 4.2 billion euros ($6.3 billion) in 2009 from 3.7 billion euros last year. Allied Irish , Ireland’s second-biggest bank, raised its bad-debt forecast for this year on Nov. 18 by 1 billion euros to about 5.3 billion euros as losses on property loans increase. Lenders’ sensitivity to the ECB’s exit strategy was evident Nov. 20 following Trichet’s remarks at a Frankfurt conference, where he said that as markets recovered from the worst financial crisis since the Great Depression, unchecked funding might spark inflation and leave banks addicted to the aid. Hours later, the ECB toughened the rules for some collateral it accepts against loans. Starting in March, newly issued asset-backed securities must be graded AAA/Aaa from two ratings companies instead of just one. ‘Painkillers’ “Not all our liquidity measures will be needed to the same extent as in the past,” Trichet said. “Eventually, the administration of painkillers must be stopped if patients are to get on their own two feet.” The Dow Jones Stoxx 600 Index fell 0.8 percent, erasing an advance and dropping for a fourth day, the longest decline since July. Dexia dropped 2.6 percent to 5.20 euros and Commerzbank fell 3.7 percent to 6.56 euros. Trichet, 66, is signaling his next step will be to stop lending banks as much money as they want for a year after one last offering in December. While officials have discussed whether to have the interest rate on new loans track the benchmark refinancing rate, they are leaning toward sticking with a fixed 1 percent rate, people familiar with the debate said last week. Banks borrowed a record 442 billion euros in June before taking 75.2 billion euros in September. Unlimited Money The ECB also may reduce the frequency of its three-month and six-month tenders of unlimited money and cut the purchases of so-called covered bonds, said Michael Saunders , chief economist for western Europe at Citigroup Inc. in London. Policy makers won’t raise their key interest rate from 1 percent before 2011 and will keep accepting a wide range of collateral, Saunders said. “The exit plan will be a combination of tough and tender components,” he said. Even if the ECB does become less generous, banks will still have the December offering; and Guillaume Baron , a fixed-income strategist at Societe Generale in Paris, estimates there will remain an excess of liquidity in the market of as much as 135 billion euros until the end of June. That will keep the Euro Overnight Index Average , or Eonia, for loans between European banks at about 0.35 percent, he said. Trichet’s policy shift comes as the Washington-based International Monetary Fund says some banks haven’t done enough to improve their balance sheets. Euro-area lenders have recognized just 40 percent of their expected losses, compared with 60 percent in the U.S., the IMF estimated in a Sept. 30 report. The Bundesbank said Nov. 25 that German banks alone may have to write off another 90 billion euros. Weakest Capital Allied Irish, Milan-based UniCredit SpA , Banco Bilbao Vizcaya Argentaria SA in Bilbao, Spain, and Frankfurt-based Deutsche Bank are among banks with the weakest capital, Standard & Poor’s said in a Nov. 23 study. Each company had a lower risk- adjusted capital ratio as of June 30 than the average of 45 large international banks. The ECB’s strategy also may mean higher interest rates on government debt, limiting room for fiscal policy to continue stimulating growth, said Julian Callow , chief European economist at Barclays Capital in London. Banks have been recycling ECB loans into government bonds, helping reduce their yields even as countries cut taxes and increased spending. Lenders’ net-asset purchases have more than tripled to 150 billion euros, according to UniCredit. The yield on the benchmark 10-year German bund fell to 3.14 percent last week from 3.72 percent on June 5, even as the European Commission downgraded its fiscal outlook. Budget Deficits Ireland, Greece and Spain may be the most vulnerable, said Aurelio Maccario , chief euro-area economist at UniCredit in Milan. The Brussels-based commission predicts their budget deficits will exceed 10 percent of gross domestic product next year, compared with a regional average of 6.9 percent. Greece’s deteriorating finances mean the difference in yield between its 10-year security and benchmark German bunds widened to 204 basis points at the end of last week from 140 basis points on Nov. 13, the most since May. European Union finance ministers will reprimand the government this week for failing to take “credible and sustainable” measures to cut its budget gap, according to a document obtained by Bloomberg News. The extra interest investors want on Irish bonds relative to the German equivalent reached 174.9 basis points on Nov. 27, the highest since July. The Spanish spread is almost five times wider than it was at the start of 2008. Default Protection Investors are paying more to protect themselves against losses on sovereign bonds. It cost $218,000 to insure $10 million of Greek debt against default for five years on Nov. 26, up from $140,000 at the end of October, while in Ireland it cost $170,000, up from $138,000. The comparative price in Germany was $25,000. Greek banks are more dependent than those elsewhere on ECB funding, with 38 billion euros of loans the equivalent of 7.9 percent of total assets, according to Barclays Capital. Ireland ranks second at 5.9 percent. Greece’s central bank said Nov. 16 it had advised a number of financial institutions to be more “‘prudent” when participating in the ECB’s December offering. Some are already taking the initiative. EFG Eurobank Ergasias SA , Greece’s second-biggest lender, cut its use of the liquidity mechanisms by 50 percent, or 6 billion euros, during the past six months, Deputy Chief Executive Officer Nikolaos Karamouzis said Nov. 17. Anthimos Thomopoulos, chief financial officer at National Bank of Greece SA, said Nov. 23 that liquidity constraints were “not an issue.” The ECB is “walking a tightrope,” said Elga Bartsch , Morgan Stanley’s chief European economist in London. The macroeconomic outlook and financial-market dislocations “make an exit a finely calibrated decision,” she said. To contact the reporter on this story: Simon Kennedy at skennedy4@bloomberg.net
