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This Could Sink Banks in Greece, Portugal, Spain, and Italy

08.04.2015  |  13:29
This Could Sink Banks in Greece, Portugal, Spain, and Italy

Not that much has changed in Spain since the climax of the debt crisis during which its collapsing banks were bailed out. Some of them were recombined into a bank with a new name - Bankia - and sold to the public via an IPO that immediately sank into red ink and scandal. Spanish government debt sported yields that reflected the risks of owning it. At this time in 2012, six-month T-bills yielded over 3.2%.

Not that much has changed in Spain since the climax of the debt crisis during which its collapsing banks were bailed out. Some of them were recombined into a bank with a new name - Bankia - and sold to the public via an IPO that immediately sank into red ink and scandal. Spanish government debt sported yields that reflected the risks of owning it. At this time in 2012, six-month T-bills yielded over 3.2%.

But that part has changed. In this absurd era when risks no longer exist in a quantifiable manner, the Spanish government today joined a growing club: it issued its first debt - 6-month T-bills - with a negative yield. Spain!

But the European Commission is now contemplating pulling the rug out from under the banking miracles in Spain, Portugal, Greece, and Italy.

Turns out, these four countries have been smart in how they propped up their rickety banks. They and their banks have declared something a "high quality" asset even though it has a dubious value, no market price, and can't be sold. And they have included this totally illiquid asset of dubious value in the "core capital" of the banks. This asset significantly increases the "capital buffers" and makes the bank more resistant to shock and collapse, on paper. That's how they solved their banking crisis.

Under the rules of Basel III, these kinds of assets need to be phased out from core capital. And the banking union's top regulator, the ECB, is trying to crack down on national exceptions to European capital rules. To get around these issues, the governments in those countries have made some legislative changes to where each government effectively guarantees those dubious assets in their banks' core capital.

In theory, if a bank with this sort of core capital gets in trouble, the government would have to pay up for those dubious assets, which would be a taxpayer bailout through the back door. But even the guarantee itself is a bailout,

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because it creates core capital out of a dubious asset. And because banks in other countries supposedly don't have access to the same state guarantees, it might be illegal "state aid" in violation of European fair competition rules.

And now, according to information obtained by the Financial Times, the European Commission is gathering up evidence to determine if these guarantees by Spain, Greece, Portugal, and Italy are illegal state aid. A full probe of this issue could rattle the banks. And if the Commission declared these guarantees illegal, the banks would lose a big part of their core capital.

A cascading wave of toppling banks, from small ones in Greece to the megabanks in Italy, would be just the sort of thing Europe's new banking union needs.

These assets of dubious value are "deferred tax assets." Banks (as other companies) can carry forward their bountiful losses of prior years to offset their tax liabilities, if any, in the future. Deferred tax assets are the theoretical value of potential future tax savings, should the banks ever have enough taxable profits, and therefore enough tax liabilities, to use them.

In total, there are €40 billion in deferred tax assets dressed up as core capital in the banks of these four countries. That's how precarious these banks are. At one unnamed bank in Greece, these deferred tax assets account for 30% to 40% of its core capital. Without Greece's special state guarantee, these deferred tax assets could not be part of the core capital, and without this additional "capital," the bank would be toast.

But on paper, these crummy sorts of assets do a nice job of propping up these banks. And that's why these four countries have bent over backwards to make it happen. Why bail out rotten banks with real money when fake assets can accomplish the same?

But it's these state guarantees that are now in the cross hairs of the European Commission's competition authorities as illegal state aid to banks that are supposed to compete fairly on level ground with banks in other countries.

Interestingly, it is not the EU's top bank regulator, the ECB, that is trying to put a stop to it, or the European Banking Authority - the previous top but toothless bank regulator - that should have stopped this practice a long time ago. They might shake their head in despair, but they're not really going to crack down on their own banks and make them clean up their own mess with recapitalizations that might wipe out stockholders and some bondholders under the new banking rules.

But no. It's the competition folks at the Commission that have gotten wind of this insidious deal between government and bank for which, in the end, taxpayers are always held accountable. It's these competition folks that are raising a stink. And they have teeth. Let's see how long it will be before the ECB puts the kibosh on it.

As you would expect, when the Financial Times reached out to the governments of Greece, Spain, Portugal, and Italy, they wisely declined to comment.

Greece needs to make some smallish payments in April. But it might not be able to. That's how broke it is. So it's using its own methods to negotiate with its creditors. But it just backfired




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