On the continued European deposit flight

Yalman Onaran has written up a lengthy review of the deposit flight now ongoing in Europe. It is a reminder that Mario Draghi’s plan to backstop Spanish and Italian sovereign debt can only do so much to stop redenomination risk, the purported worry of the ECB in intervening.

A total of 326 billion euros ($425 billion) was pulled from banks in Spain, Portugal, Ireland and Greece in the 12 months ended July 31, according to data compiled by Bloomberg. The plight of Irish and Greek lenders, which were bleeding cash in 2010, spread to Spain and Portugal last year.

The flight of deposits from the four countries coincides with an increase of about 300 billion euros at lenders in seven nations considered the core of the euro zone, including Germany and France, almost matching the outflow. That’s leading to a fragmentation of credit and a two-tiered banking system blocking economic recovery and blunting European Central Bank policy in the third year of a sovereign-debt crisis.

“Capital flight is leading to the disintegration of the euro zone and divergence between the periphery and the core,” said Alberto Gallo, the London-based head of European credit research at Royal Bank of Scotland Group Plc. “Companies pay 1 to 2 percentage points more to borrow in the periphery. You can’t get growth to resume with such divergence.”

Lending Rates

The erosion of deposits is forcing banks in those countries to pay more to retain them — as much as 5 percent in Greece. The higher funding costs are reflected in lending rates to companies and consumers. The average rate for new loans to non- financial corporations in July was above 7 percent in Greece, 6.5 percent in Spain and 6.2 percent in Italy, according to ECB data. It was 4 percent in Germany, France and the Netherlands.

Some of the decline in deposits is because German and French banks are reducing their exposure. They cut lending to their counterparts in the four peripheral countries plus Italy by $100 billion in the 12 months ended March 31, according to the latest data available from the Bank for International Settlements. ECB data count interbank lending as deposits, as well as money being held for corporations and households.

Banks in the core countries also have been reducing their holdings of Spanish, Portuguese, Italian, Irish and Greek government bonds. At the same time, lenders in the periphery have been buying more of their own governments’ debt. That has further contributed to the fragmentation of credit along national lines, as banks collect deposits from people and companies in their own countries and lend internally.

Is the new Outright Monetary Transactions program going to end this deposit flight? I certainly don’t believe it will, especially given the continuing losses in Spain’s property sector where 1 out of every euros in loans is now bust. Spain’s banks have a record 169.3 billion euros of bad loans – and this figure is rising.

Moreover, if the Spanish government is forced into a Troika program that requires them to take on more austerity despite the increasing social unrest, we should expect the pace of writedowns at Spanish banks to increase, meaning more money will be needed to bail out Spanish banks. And this is a problem. As I told Yalman:

If Irish or Spanish lenders burdened with losses from their nations’ housing busts were allowed to fail, German and French banks would lose money on loans to financial institutions in Europe’s periphery.

The ECB’s latest plan to buy the sovereign bonds of some countries will continue the trend of bailing out German and French banks, Harrison said.

“The leaders of the core countries won’t let the periphery countries write down their debt because then they’d have to capitalize their own banks losing money from those investments,” Harrison said. “This is a good backdoor bailout of their banks, but it still doesn’t solve the solvency issue of Spain or Italy.”

Bottom line: the OMT program buys a lot more time. But the solvency issue is still on the table for both sovereign and banks. The question now as ever is who is going to pay for the losses.

Source: Deposit Flight From Europe Banks Eroding Common Currency, Bloomberg