Monday, May 21, 2012

Citi's Matt King on deposit flight likely to pick up speed in the EU

Citi's Matt King has published a note (hat tip ZeroHedge) in which he lays out the case for why deposit flight from the EU peripheral countries is likely to accelerate.

The trouble, as we see it, is that bondholders are not at heart the wolf pack Swedish Finance Minister Anders Borg famously made them out to be. Sheep, or perhaps wildebeest, would be a more accurate description.

Bondholders and depositors alike have only limited upside, but lots of downside. They therefore tend to graze quietly upon their coupons or interest payments, relying on others – such as the rating agencies – to warn them of oncoming fundamental risks. Even if individual investors are often very sophisticated, they are constrained by those who set their benchmarks and risk guidelines, which tend to be much slower moving.
Please notice the reliance on others for a warning about oncoming financial risks.

This confirms your humble blogger's observation that market participants are dependent on the financial regulators to both properly assess the risk of the banks and to communicate this risk.  Communication which the financial regulator's focus on safety and soundness prevents from occurring.
Once the flock has been disturbed, though, it can run quite quickly. 
Just look at what happened with structured finance and private labeled RMBS deals.
And once it has changed its mind about a given risk, it can be almost impossible to get it to turn back.
What is required to get it to turn back is ultra transparency as it is only with ultra transparency that all the information necessary for independently assessing the risk of a bank or security is available.
Those dropping Spain and Italy from their benchmarks, shifting their mandates towards AAA-only, or moving deposits away from peripherals, are very unlikely to return in a hurry. If anything, we think the risk is of acceleration. And it would seem that, having been disturbed once or twice already, investors are proving more alert to potential signs of danger in Spain and Italy than they were in Greece, Ireland and Portugal. Although the threshold for domestic capital flight looks to be higher than that for a retrenchment by foreigners, there is every sign that foreigners are pulling back already.

How far is the flock likely to run? In Greece, Ireland, and Portugal, foreign deposits have fallen by an average of 52%, and foreign government bond holdings by an average of 33%, from their peaks (Figure 18). The same move in Spain and Italy, taking into account the fall that has taken place already, would imply a further €215bn and €214bn in capital flight respectively, skewed towards deposits in the case of Spain and towards government bonds in the case of Italy (Figure 19).

Although large, if these flows occur slowly enough, they might not represent a major problem. After all, Portugal’s banks have managed to replace fleeing foreign deposits with domestic ones, and ECB repo should allow a further ramp-up in banks’ holdings of government bonds.

But we think the risks are skewed towards larger outflows occurring considerably more rapidly. Admittedly there are a great many unknowns, including the potential policy response. But none of these estimates allow for the possibility of domestic deposit flight. In the case of a Greek exit from the euro, that outcome seems highly likely. Nor is there any sign that the flight from Ireland and Portugal is diminishing (if anything, we expect the opposite).
Something that this blog has been documenting.  Apparently Mr. King also sees hiring third parties like BlackRock Solutions and Goldman as worthless in slowing down the run on the banks.
Moreover, banks’ appetite to buy further government bonds may prove limited if they start to suffer deposit flight – and all the more so if they suspect that deposit flight stems in part from their holdings of government bonds
A negative feedback loop.
Above all, though, we think capital flight, like so much in markets, is a self-reinforcing process. Provided other depositors and bondholders are grazing quietly, there is no reason to run. But as risks come ever more into the spotlight – whether through the TARGET2 imbalances, benchmark shifts or the threat of EMU exit in Greece – the unattractiveness of the risk-reward becomes ever more obvious.
To our minds, capital flight will stop only once there is decisive policy intervention. The longer investors have to wait for this, the more decisive it will need to be. Even a Euro area-wide deposit guarantee scheme might struggle to be credible if investors fear the incentives for redenomination are strong enough...
What is needed to prevent the capital flight in the first place is a combination of a Euro area-wide deposit guarantee scheme plus the adoption of the Swedish model with ultra transparency.  The adoption of the Swedish model with ultra transparency sends the signal that the banks will be cleaned up and henceforth be subject to market discipline to restrain their risk taking.
Quite simply, investors in ‘safe assets’ need to be reasonably sure they will get their money back. Foreign investors in peripherals can no longer be sure of that.


Anonymous said...

The complete TARGET2-debate:

Richard Field said...

I wrote a post a while ago asking the question of whether the massive imbalances under TARGET 2 are cause for concern.

The conclusion is it depends on whether the Eurosystem is making sure that it has collateral worth more than the value of the loans it extends.