A couple of ECB watcher takeaways from Banca Monte dei Paschi di Siena (BMPS) Q1 2016 results

(1) The value of the Italian government bonds on the BMPS balance sheet increased a remarkable 25% QoQ (+8% YoY) to €22,5bn. Why? The same reason there was a +42% QoQ (+23% YoY) increase in Portuguese government bonds on the balance sheet of Millennium BCP to €4,4bn — as a hedge against the decline in net interest income derived from deposits [which is a function of Euribor, and the curve has significantly tightened following the expected and realised deposit rate cuts in December and March. Some of the increase in value is due to an increase in market value of the existing stock, but a small fraction]. These are non-trivial amounts, even when benchmarked against the ECB’s PSPP they correspond to a quarterly increase of ~0.4x and ~1.3x of what the Banks of Italy and Portugal purchased in Italian and Portuguese sovereign debt in April.

From both BMPS and BCP’s perspective this is a perfectly sensible strategy — the market value of sovereign debt has an inverse correlation to the yield across the Euribor curve [one of the main channels through which monetary policy works]. Of course, the hedge means MBPS and BCP are taking on more sovereign credit risk, but they are likely more prepared to accept this than in “normal” conditions as PSPP significantly mitigates sovereign credit risk [it also amplifies the aforementioned inverse correlation]—for the foreseeable future (risk of PGBs dropping out of PSPP aside) both banks would have no problem exiting the hedge and booking a capital gain.

But from the perspective of the political debate about the ECB’s low rates, and the spillover this has on the Eurozone institutional debate, it throws up a few interesting issues. To date, the Governing Council’s discussion on the perverse side effects of negative deposit rates [at least what we see in the accounts] has focused on the impact on retail banking profitability (derived from net interest income) — which is of course important—but there has been little, if any, debate on the wider consequences of banks actions to mitigate the impact.

BMPS and BCP’s balance sheets demonstrate [at least in the case of two periphery banks, let’s see what the rest of EZ retail bank earnings season and the aggregate data available in a few months bring] that the ECB’s reduction of deposit rates to the current level, coupled with its forward guidance, has had a direct consequence of intensifying the domestic sovereign debt-bank “doom loop”. This is two steps back at a time of particular sensitivity around bank holdings of domestic sovereign debt for the Banking Union debate [after a step forward last year when a lot of periphery banks sold debt to to the ECB via PSPP to book a juicy capital gain]. Germany has said it is unwilling to compromise on the the essential Deposit Insurance Guarantee Scheme unless measures are agreed to curb bank domestic sovereign exposures via hard limits and scrapping the zero capital weights — something many periphery countries, especially Italy, are fiercely opposed to. The increases discussed here provide a two pronged argument for Germany in its line of attack: it both demonstrates how entrenched the problem is, and how urgent it is to solve in the context of the current low rate environment [the flip-side of the argument: how disruptive any near-term change would be, and that this IR/credit hedge is essential in the context of the current low rate environment—as allows the ECB to set appropriate policy without having too adverse an impact on monetary policy transmission].

For me it compounds the reasons the ECB will be concerned about cutting the deposit rate deeper into negative territory—only recently Executive Board members have been sounding out sensitivity on the subject of bank concentration risk. Of course the ECB’s first priority is achieving its mandate, but they are also acutely aware of the political momentum required to get the completion of Banking Union going [essential to fulfilling its mandate — and probably more importantly, ensuring the survival of the EZ — over the longer term] and the delicate institutional role they play in the fine tuning the policy balance to make that happen.

What does it mean for monetary policy? Since the March package I’ve been in the camp that a strong NEER EUR appreciation would be required for another 10bp cut — this development makes me slightly intensify my definition of “strong”. Besides, to what extent the ECB can still influence the FX channel is another debate (see Q2). All eyes on the Fed for now.

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(2) €0,8bn of performing loans became on BMPS balance sheet became non-performing in Q1. The good news is that’s down 41% against the €1,4bn per quarter average for 2015. The bad news is the gross NPL stock is still growing (all be it at a slower pace than in 2015) and management still don’t know when this figure will peak — which suggests they don’t have a very positive outlook on the Italian macro environment.

As a keen follower of the GACS/Atlante debate, the most interesting revelation on the earnings call was that the bank haven’t incorporated any impact of GACS/Atlante into their updated estimates of the 2016–2018 disposal rate—the bank seems to have doubled down on its strategy of improving the pace of on-balance sheet recovery.

This squares with what Ignazio Angeloni said to La Republica on Wednesday, “The fund has limited scope, not with regards to the first steps it has said it will take [saving Vicenza/Vento from bail-in], but with regards to the overall size of the bad loans”.

Almost all of the analyst questions on NPLs were focused on the new decree the Italian government recently approved to speed up recovery. The BMPS CEO simply said it is a “positive”, without much enthusiasm — there is considerable doubt to if it will significantly speed up the resolution of existing loans, as opposed to just new ones.

All said, very discouraging.

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