Euro Banks Hoard Cash, Expecting Downturn

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The Bank of Italy building is seen downtown Milan
The Bank of Italy building is seen downtown Milan, November 25, 2011.

(REUTERS) -- European banks are preparing for a potential worsening of the region's sovereign and banking crisis, with many firms stockpiling cash and cutting back on loans to new clients as they seek to protect themselves against a possible seizing-up of financial markets.

Faced with 650 billion euros of debt coming due this year - almost 40 percent of which matures before the end of March - lenders are choosing to build up a cash cushion to ensure they can cover redemptions, creating a squeeze on the wider economy in the process.

Such hoarding illustrates the nervousness of lenders even after the European Central Bank injected 489 billion euros of cash into the banking system in December. Cash deposits at the ECB have ballooned since then, reaching a record 528 billion euros this week - higher than after the Lehman Brothers collapse.

"The big concern is that things might get worse," said Bernd Hartwig, treasury manager at Nord/LB. "Political decisions are taking too long and most banks are building up liquidity just in case something happens. They are very worried that a new crisis could be a bigger than 2008."

System-wide hoarding is the reverse of what happened the last time central banks injected hundreds of billions of long-term money into the system. Then, banks moved quickly to put the money to work and generate returns, sparking bond and equity market rallies - and economic growth.

The US Federal Reserve almost trebled the size of its balance sheet to more than $2 trillion in the months after the collapse of Lehman Brothers, pumping cash into the banking system through programs such as the Term Auction Facility. The ECB grew its balance sheet by about a quarter in that time.

WAIT AND SEE

But this time round, many banks have taken the decision to wait. While some have paid off interbank loans - so boosting the cash reserves of creditor banks - and a handful have bought some domestic government paper, most are choosing not to commit new cash to assets or to lending.

"For many banks it's all about survival and they have just bought more time for themselves with the ECB money," said the treasurer of one of Europe's largest banks. "None of the fundamentals have been addressed. People are in standby mode - you might need lots of liquidity at short notice."

There are other factors at work, too. Banks face strict new capital and liquidity rules, and many are planning to shrink their balance sheets in order to meet those targets - not buy more. They also do not want to commit to new assets because selling out could prove difficult should conditions worsen.

"The problem is completely different from 2009," said Elie el Hayek, global head of interest rates at HSBC. "Back then, a big proportion of the money went into assets. This time, banks cannot do that simply because they need to protect their capital and liquidity. They know any mark-to-mark losses will eat into those buffers so they don't want to take the risk."

PREMATURE OPTIMISM?

Recent market optimism might also be premature. Although recent sovereign bond deals have been well bid, bankers say buying in secondary markets has been weak, and that there are few signs of banks using fresh cash to buy up European government bonds.

The lack of demand in secondary markets is partly due to the stigma now attached to peripheral bonds. Investors and regulators have started to ask more questions about such exposures, with the European Banking Authority penalizing banks for holding Spanish and Italian bonds during recent stress tests. Italian 10-year bond yields have fallen slightly in recent weeks, but have not dropped below 6.3 percent since early December.

"Banks are coming under political pressure to buy in the primary market," said Pavan Wadhwa, head of global interest rate strategy at JP Morgan. "Given the lack of demand in the secondary market for peripheral paper, we estimate the ECB would need to more than double its current pace of purchases of Italian and Spanish paper to stabilize markets at the longer end."

On the funding side, a recent fillip in bank bond deals also masks deep underlying problems. Banks have raised more through unsecured bond issues in January than they did in the whole of the second half of 2011. But only the highest rated banks have been able to get deals done.

That leaves hundreds of other firms with debts coming due and no prospect of tapping private investors. At the ECB's first three-year long-term refinancing operation in December, 523 banks collectively borrowed 489 billion euros. Bankers expect the February three-year LTRO to be popular too.

"The concurrent increase in deposits at the ECB is consistent with banks building up funds to replace maturing debt," Fitch Ratings said in a report this week. "We expect the next three-year funding round in February to see a similarly high level of take-up."

NEGATIVE CARRY

Although banks earn little by depositing cash at the ECB - a measly 0.25 percent - and so effectively lose money because they are paying a much higher rate to borrow the cash in the first place either from the central bank or privately, treasury officials and CFOs feel justified making those losses.

"Running a liquidity position is a cost," said the treasurer at a bank facing one of the highest refinancing hurdles this year, who confirmed that the bank had tapped the ECB in December only to deposit the money right back there. "But taking cheap money from the ECB is going to increase your liquidity and placate investors and shareholders."

High deposits at the ECB are not necessarily being made by the same banks borrowing from the central bank - although there is some anecdotal evidence of a handful doing that. Rather, high deposits are indicative of cash being hoarded on a system-wide basis.

For now, banks say they will sit on the cash until the larger problems are sorted. "Do I want new customers with high risk and low rates? I don't think so," said one treasurer.

If, however, confidence returns to the markets and banks become less fearful, a huge bounce in asset prices is possible. Some believe that the slow build-up of cash at the ECB creates the potential for a massive asset binge should nervousness ease and bank funding stabilize. The ECB balance sheet recently reached a record 2.7 trillion euros, the highest in its short history.

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