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* BPCE, Credit Agricole, SG and HSBC double French exposure
* Intesa , UniCredit, Monte dei Paschi, UBI up Italian debt
* Banks attracted by low capital charges on government debt
By Gareth Gore
LONDON, Oct 29 (IFR) - Major European banks doubled theirexposure to government debt in the two years running up to thelatest stress tests despite a worsening in the economicfundamentals of many countries, according to an IFR analysis ofEuropean Banking Authority data.
At a time when lending to the private sector plummeted,these banks continued to extend credit to strugglinggovernments, with many re-entering - and even doubling down on -the same kinds of carry trades that some abandoned in the throesof the eurozone crisis in 2011.
BPCE, Credit Agricole, Societe Generale and HSBC doubledtheir holdings of French government debt, for example, adding81bn of bonds and loans to their books. Italy's four biggestbanks added 53bn of domestic public debt, while mid-tierSpanish banks also lent more to Madrid.
"The carry trade is still too tempting for many banks, eventhose that wanted to de-link from sovereigns not that long ago," said Nikolaos Panigirtzoglou, a strategist at JP Morgan, onhearing of the IFR analysis. "They see it as an easy way toboost profits and are perhaps complacent to debt sustainabilityrisk on some countries."
The analysis takes the sovereign exposures of banks at theend of last December, when the EBA took a snapshot of bankbalance sheets for its most recent stress tests, and comparesthem to holdings in September 2011, the last EBA examination ofbanks' balance sheets before the European Central Bank injected1trn of liquidity into the system via its longer-termrefinancing operations.
BPCE has the biggest exposure of any bank monitored by theEBA in the exercise to a single eurozone sovereign, with itsFrench public debt position almost 83bn at the end of December,according to the latest stress test data. That is almost twicethe 42.5bn position it held in September 2011.
Credit Agricole doubled its French debt exposure to 50.7bnfrom 25.1bn previously, while Societe Generale's exposure grewto 35.4bn from 20.4bn. HSBC now has the biggest exposure ofany foreign bank to French public debt at 35.2bn, up from14.1bn.
Italian banks Intesa Sanpaolo, UniCredit, Banca Monte deiPaschi di Siena and UBI Banca together added 53bn of Italianpublic debt between September 2011 and last December. IntesaSanpaolo has 77.3bn of exposure, and UniCredit 56.7bn. Montedei Paschi failed the latest stress tests and was ordered toraise 2.1bn in fresh capital, sparking a 22% decline in itsshare price on Monday.
Meanwhile in Spain, while major lenders BBVA and BancoSantander have cut their exposure to domestic public debt,mid-tier banks including La Caixa, Bankia and Banco de Sabadellall increased their holdings - with some of the smallerinstitutions doubling their positions.
And though the EBA data only give a snapshot of bankpositions in December, recent ECB figures illustrate that theproblem has worsened since then.
The sovereign bond portfolios of eurozone banks reached arecord 2.4trn in September, according to the ECB. That is 30%higher than in 2011, accounting for 7.7% of all assets owned bythe entire eurozone banking system.
HAPPY ENOUGH
These portfolio purchases have helped bring down sovereignbond yields and eased pressure on debt-riddled governments,which in turn convinced some regulators to turn a blind eye tothe rapid accumulation of government debt. Buying from bankshelped bring down Italian and Spanish 10-year bond yields torecord lows of 2.3% and 2% this year. Both were trading above 7%just two years ago.
Banks are of course also happy to buy government debt,because such positions can be taken without holding regulatorycapital, unlike other loans which must have reserves heldagainst them. Banks with capital constraints thus can borrowcheaply from the ECB - and reap the profits of the trade withoutthe need to muster additional capital.
"The carry trade is an old habit many banks can't kick,"said Alberto Gallo, a credit strategist at RBS. "A lot of theEuropean banks - even ones that passed the stress tests - arecapital-constrained, so the returns from non capital-absorbingsovereign debt look more attractive than loans."
"It is much trickier to lend to the real economy becauseregulatory hurdles are greater, making it less appealing thancarry trades," said JP Morgan's Panigirtzoglou. "Risk weightingsare zero for government bonds and can be as high as 100% forother types of lending."
The prospect of further quantitative easing from the ECB,which is likely to come in the form of sovereign bond purchases,as well as a pledge from President Mario Draghi to "do whateverit takes" to save the eurozone have left many banks convincedexposure to government bonds is safe and can be offloaded or rundown over time, say analysts.
NOT EVERYONE
Still, some banks are reducing their exposures. DeutscheBank and BNP Paribas both took heavy losses after Greecerestructured its debt in 2012. EBA data show that, betweenSeptember 2011 and last December, Deutsche cut its exposure toSpain and France, though it increased its Italian exposureslightly. BNP Paribas cut its Spanish and Italian positions butupped its exposure to France.
"Some banks, especially those with large internationaloperations, weigh risks that smaller domestic-oriented banksdon't - reputational and debt sustainability risks," saidPanigirtzoglou.
National regulators, which are typically close to their owngovernments, have until now had jurisdiction over eurozone banksand their sovereign exposures. That all changes next month, whenthe ECB takes responsibility for larger and mid-sizedinstitutions. But analysts doubt the central bank will force arevision of the rules.
"When the ECB will become Europe's bank regulator, there maybe a conflict of interest between that function and theirmonetary policy mandate," said Gallo at RBS. "On the one handthe central bank wants yields to be low, and banks to buygovernment paper. On the other, they need banks to be strong -and not only survive on carry trades. The solution may be toreform the weak banks upfront."
But with debt-to-GDP ratios rising to what some considerunsustainable levels, the possibility looms of more sovereignrestructurings over the medium term - and deep losses for bankswith large exposures. Debt-to-GDP ratios stood at 92% in Spainand France and 128% in Italy at the end of last year, accordingto Eurostat. Greece's ratio was 129% in the last full yearbefore asking for a bailout.
"Italy and France both have unsustainable governmentfinances, and there will have to be a debt restructuring acrossthe periphery - including France at some stage in the future,"said Megan Greene, chief economist at Manulife Asset Management."These government bond holdings may look fine to regulators now.But they could very quickly become a big problem." (Reporting by Gareth Gore; Editing by Marc Carnegie and MatthewDavies)
