It's not over yet:
When these little PIIGs go to market

Last year’s Eurozone debt crisis is not over, warns AJAY RAWAL. For banks mired in the $3.8 trillion debt of Portugal, Ireland, Italy, Greece and Spain, restructuring is the key to survival in 2011.

History will look back on 2010 as the year of the European sovereign debt crisis. At any point over the last 12 months you would have been forgiven for losing perspective on where the European and global economies really stood. And the confusion would have been compounded by the daily deluge of economic news and analysis.

The Eurozone continued to feel the aftershocks of the sharpest fall in global economic activity since the Great Depression. This has undoubtedly been the most threatening financial situation Europe has faced in decades.

After two years of constant “crisis”, there is a need to recognise that we are in a period of sustained and radical change. This crisis began as a banking industry issue, characterised by the run on Northern Rock in 2007. This in turn mutated into a sovereign issue, but is now gradually morphing back to a banking issue.

Nothing in this journey is particularly surprising, nor different from past experience. However, the unprecedented level of inter-connectedness of global financial markets has accelerated the negative effects. In Europe, policy has moved significantly in the direction of fiscal consolidation, with looser monetary policy to support the economy. But this is much easier to achieve when you’re managing only a single economy as in the UK, as opposed to the Eurozone where there has been significant divergence in economic growth.

Over the course of the year, the markets have focused in turn on Greece, Ireland, Portugal, Spain and Italy. With Greece and Ireland accepting bailouts totalling €€110bn and €€85bn respectively, the “sovereign solution” is becoming apparent. In return for implementing tough austerity measures, each country has been provided with funding that will avoid them needing to raise money in the markets for the next three years.

But, while the individual countries have been stabilised, Europe as a whole is not out of the woods. We moved to a new and potentially dangerous phase in December as jittery international markets sent Spain’s borrowing costs soaring. The focus was no longer on just the smaller countries.

Attention has rightly been focused on the so-called PIIGS countries (Portugal, Ireland, Italy, Greece and Spain), given they have a combined €3.8tn of debt outstanding*. They all continue to run very high deficits. However, despite the acronym, it is a mistake to lump the countries together. The situation in each country is different: Ireland’s issues primarily concern banking and property; but Greece and Spain face sovereign problems.

Despite these important differences, the market has taken fright, and regrettably all the players have been tarred with the same brush. Within these countries, only banks which are very well diversified and generate significant parts of their income internationally (like Santander in Spain) will be able to make a case to be treated differently by the markets.

For the major European economies the picture is no less alarming. Britain, France and Germany have a combined exposure of over €2tn to the PIIGS countries*. Whilst Britain is more exposed to its near neighbour Ireland, France’s biggest exposure is to Italy, which is in debt to its Gallic neighbour to the tune of a staggering 20% of its GDP*. German exposure is more evenly spread, though it remains unclear how much Irish banks owe German lenders.

Of equal significance to individual country exposure is the fact that significant balance sheet risk is being transferred to the European Central Bank (ECB ), as it provides support to the banks of affected countries. Headlines aside, it’s becoming increasingly clear that investors are looking for a Europe-wide systemic solution.

The IMF has played a key support role, both in elevating the issues to get the attention of European leaders and in participating in the Greece and Ireland packages. The IMF also appears to be encouraging Ireland to kick start the restructuring and sales process.

Against this backdrop, the European banking industry as a whole has appeared slow in moving to deal with its problems. There are a number of reasons for this. Most banks fear that “forced sales” would not yield the best results and they see little value in selling assets at reduced prices. The recovery in some asset values, such as property in London, has shown the benefit of not rushing. Additionally, whilst most banks would welcome increased liquidity, they are fearful of creating additional capital holes in their already weakened balance sheets.

While this is a credible short term strategy, it is not sustainable in the long term. The winding down of special liquidity schemes will require banks to shrink their balance sheets. Secondly, whilst there has been some recovery, this is not uniform across all asset classes and will be insufficient in many cases for banks to recover 100% of the loan value. Thirdly, banks were focused on stabilising themselves last year and gathering data on their portfolios. They will be much better placed to complete transactions in 2011.

Private equity has emerged as a serious purchaser of banking assets. This spans cash generative businesses such as payments, which do not carry balance sheet risk, loan portfolios such as property loans which have been the focus in Ireland, and even direct investments in banks.

In the UK, JC Flowers has made an investment in Kent Reliance. This innovative structure could facilitate new capital coming into a UK building society sector which struggles to raise new capital as building societies are owned by their members. National governments have a critical role to play in supporting sales, both through their stakes in the banks and also in providing backstops. The US has been highly effective in making this work.

A clear framework is needed for managing countries that experience difficulties and this must include the acceleration of the restructuring of banks, particularly in Ireland, Greece and Spain.

In December 2009, the FSA ’s Hector Sants said that even the biggest banks should be allowed to fail – and that orderly failure with minimal cost to the economy should not be seen as a regulatory failure. Sants is correct, but regulators must develop clear rules to allow banks to “fail” in a controlled manner. German chancellor Angela Merkel has lobbied hard for bondholders to share the pain of EU bailouts and certainly clear rules for burden sharing with bond holders need to be established.

In conclusion, the continued economic instability across Europe means that 2011 is set to be another momentous year for the banking industry. Success and failure for countries and banks alike will be determined by how quickly they respond to what happens next.

(*Source: Bill Marsh / New York Times / Bank for International Settlements)

The 2011 conundrum
In the coming year, we’re faced with a large number of uncertainties – key questions whose answers it’s still impossible to predict:

WILL THE MEDICINE WORK? How quickly will individual countries respond to the EU/IMF medicine, and will the timescales for deficit reduction be relaxed if the pain involved is too much?

STRONGER STRESS TESTS? The results of the next set of European bank stress tests. The first sets were largely discredited as not tough enough. The next set need to identify the banks with problem balance sheets.

WILL BANKS SHAPE UP? What is the desired shape of the future banking systems in each PIIGS country? In Ireland it looks like the larger institutions will be shrunk into purely domestic banks and the smaller players will be consolidated. In Spain and Greece, bank mergers are likely to be a major feature.

IS SHRINKING THE ANSWER? Whilst consolidation and downsizing make sense in the short term, what are the long term implications for the structure of the banking industry and future levels of competition?

CAN PRIVATE EQUITY HELP? There has been much talk of private investment in the banking industry but few deals as yet. How quickly will private investors be brought in as part of the solution?

HOW TO WOO INVESTORS? Will long investors (pension funds, fixed income funds, insurers) support countries and banks when they return to the markets?

HOW TO BIND THE BONDHOLDERS? What will future burden sharing for bondholders actually mean?

Bullet-proofing the banks
There are practical steps banks should be taking now to safeguard against the continued economic uncertainty:

GOVERNANCE: Banks need to reshape their business models, with increased focus on governance, risk management, and efficient delivery models that focus on what customers actually need

CORE FOCUS: Take charge of their own restructuring plans, and make tough decisions on what is core or non-core

PROVISIONS: Tie down their provisions so there is no more bad news, and they are also in a position to deal with new sources of capital

PRIVATE EQUITY: Engage with the private equity community and do some deals. The market needs to set a clearing price from which future momentum can be built

GROWTH PLATFORMS : Where organisations are being slimmed down, senior management needs to look at how a platform for future growth can be rebuilt, rather than just burning what they originally had

STRESS RESOLUTION: Put in place resolution plans that can be implemented in case a bank comes under stress

ACCELERATION : Speed-up the implementation of all of these measures!

AJAY RAWAL is a senior director in the financial services team at the global professional services firm, Alvarez & Marsal

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