Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 21 March 2012

Banks-v-Sovereigns: Old idea in new blog


Sovereign credit and health of the domestic financial system are usually interlinked. Imminent sovereign default can and does lead to capital flight and run on the banking system. Conversely, a banking crisis inevitably causes recession and worsening of sovereign finances. The current European sovereign debt crisis started as a banking crisis and has now engulfed both sovereigns and their banks.

One of the paradoxical consequences of this crisis and subsequent ECB support has been the reversal of integration in the European banking sector. This can be seen from:
  1. Obliteration of cross-border unsecured interbank lending
  2. Decrease in holding of peripheral sovereign bonds by foreign banks as domestics fill the gap
  3. Divestment of non-domestic operations to raise capital/reduce RWAs
  4. Market perception leading to sovereign and bank funding costs being linked
All these factors add to the imbalances tearing the Eurozone from within (and are the other side of the TARGET2 coin). Further macro-economic analysis of these will be undertaken in some future note. From a trading perspective, it is only important to recognize the strengthening sovereign-bank link and investigate how this might be exploited.

One of the ways that the sovereign-bank link can be used is in the hedging of sovereign quanto positions where dealers have bought EUR-denominated CDS and sold USD-denominated CDS. Instead of hoping for the market to die and their exposure roll off, they can buy sovereign CDS in USD and sell correlated bank CDS in EUR to create an offset. The same trade is also a way to cheaply create a position with low mark-to-market volatility and which pays off in case of crisis intensification.

The other way of exploiting the sovereign-bank link is in the case of nationalised banks or those who are guaranteed to be nationalised due to TBTF fears. Selling higher spread bank CDS and buying sovereign CDS earns carry while reducing outright credit exposure.

Given the increasing dependence of banks on their sovereign, intuitively in most cases credit spreads should converge as default correlation approaches 1. However, this is not the case as seen below in table 1 which shows the 16 most liquid European banks. Spreads for diversified groups such as HSBC, Santander, etc are expected to diverge but most of the others should not be much different from their sovereign. For example it is inconceivable that an Italian default will leave Banca Intesa unscathed as it earns about 80% of revenues from Italy and owns €60bn (~125% of equity capital) of Italian government bonds.

Table 1: 5Y CDS spreads for banks and their sovereigns
Sovereign (spread in bps)
Bank
Bank Spread (bps)
Difference (bps)
Italy (353)
ISPIM
271
82
Italy
MONTE
348
5
Italy
UCGIM
297
56
Spain (408)
BBVASM
290
118
Spain
SANTAN
281
127
France (163)
BNP
173
-10
France
ACAFP
217
-54
France
SOCGEN
237
-74
Germany (68)
DB
129
-61
Germany
CMZB
184
-116
UK (62)
BACR
150
-88
UK
LLOYDS
241
-179
UK
HSBC
115
-53
UK
RBS
250
-188
Switzerland (36)
UBS
151
-115
Switzerland
CS
129
-93
Source: Bloomberg (Banks shown are all constituents of iTraxx® Financials index)

Non-convergence is not a relative value opportunity. The reason for such persistent spread divergence is due to demand and supply and other technical factors which are enumerated in the table below:

Reason for non-convergence of spreads
Effect
Highly levered/non-viable banking operation (eg. Icelandics, Irish)
Sovereign credit spread lower
PSI leads to sovereign default but bank bondholders are unaffected as banks are recapitalised/nationalised.
Bank credit spread lower
Currency difference between sovereign (USD denominated) and bank (EUR denominated) CDS. For a major Eurozone sovereign (i.e. Italy, Spain) EUR protection is worth much less.
Bank credit spread lower
Sovereign’s ability to engineer default through currency depreciation.
Sovereign credit spread lower

On this basis, Italian and Spanish banks should trade below their sovereign and UK, US, Swiss banks should trade above. The case for France and Germany is more complicated because of their being the main pillars propping up the common currency but without direct control of monetary policy. But, it can be argued that if it came to it, default through depreciation will be their preferred route as well. Therefore the market is correctly pricing relative value between banks and sovereigns. Even though default correlations are tending to 1, CDS technicalities prevent convergence.

Coming back to the two ideas elucidated above, a long CDS position in Italy versus a short CDS position in ISPIM effectively hedges Italy quanto risk. Moreover, as a position in its own right, it benefits from not being a “naked” short on Italy which might displease the regulators. A return of scepticism will cause both spreads to widen out but because Italy is an important constituent of the Eurozone, the EUR will fall a lot relative to the USD reducing the losses on the ISPIM leg. This also works for Spain where the Latam diversification of its two largest banks (rather the market’s perception of it) is an added benefit. 

Selling CDS on RBS/LLOYDS and buying it on UK (in EUR) enhances the carry for little extra risk. The chances of them becoming independent or being liquidated are slim in the medium term. They should be priced as a National Banking Service rather than the entities which they were at the time of the credit crisis.

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