Some banks are exposed to the risk of a sovereign debt crisis directly through bond investments, such as by owning, say, Greek bonds.
Yet even banks without any direct exposure to troubled government bonds could be slammed by a sovereign crisis as well.
That’s because in a sovereign debt crisis, underlying benchmark interest rates would likely skyrocket for troubled nations.
This would sharply increase funding costs for many banks, which is bad news for financial businesses who borrow short term and lend long term, earning a spread.
At best this would reduce their profits substantially, at worst it could lead to substantial losses if suddenly higher funding costs meant that banks were earning negative spreads on certain lines of business:
The bigger concern, however, is not banks’ direct exposure to government bonds, which average just 5% of euro-zone banks’ assets, but the impact on their financing. The costs of funding for banks on Europe’s periphery are rising in tandem with the allegedly “risk-free” benchmark rates on the bonds of troubled European governments. Steep downgrades of the sovereign-debt ratings of countries such as Portugal, Greece and Ireland would probably translate into immediate rating cuts for their banks, as well as higher capital charges on banks’ debt holdings and bigger haircuts when using this debt as collateral. Regulators are busy designing rules forcing banks to hold more government bonds on the assumption that they are the most liquid assets in a crisis. That premise may not hold for every country’s debt.
A second concern is that the premium that investors demand for holding bank debt may also widen above the benchmark “risk-free” rate. “If governments are either less willing, because of competing pressures on budgets, or are unable to provide support then that could have a material impact on bank ratings,” says Johannes Wassenberg of Moody’s, a rating agency. The consequences of even small changes in a bank’s borrowing costs can be extreme. JPMorgan, an investment bank, reckons that an increase of just 0.2 percentage points in the borrowing costs of British banks such as Lloyds Banking Group and Royal Bank of Scotland would trim their earnings by 8-11% next year, assuming they could not immediately pass these costs on to customers.
(Via Abnormal Returns)