Dozens of banks across Europe have sold large quantities of insurance to other banks and investors that protects against the risk of ailing countries defaulting on their debts, the latest illustration of the extensive financial entanglements among the continent's banks and governments.
New data released last week by European banking regulators suggest the risks of banks suffering losses tied to European government bonds could be higher and more widespread than previously realized.
The numbers show European banks have sold a total of €178 billion ($238 billion) worth of insurance policies, in the form of financial derivatives known as credit-default swaps, on bonds issued by the financially struggling Greek, Irish, Italian, Portuguese and Spanish governments. If those bonds default, as some investors fear they might, banks could be on the hook for making large payments to the holders of the swaps.
The banks have at least partly insulated themselves from such potential losses by buying large quantities—roughly €169 billion worth—of credit-default swaps tied to the same bonds, apparently in large part from other European banks, according to European Banking Authority data.
The disclosures highlight another layer of risk interwoven through the continent's banking system. Already, investor fears about the hundreds of billions of euros of potentially risky government bonds European banks are holding have eroded confidence in the industry, making it harder for many banks to finance their daily operations.
One key question in gauging the risks facing individual banks is from whom they purchased protection. The EBA data doesn't provide an answer. Some big banks, including Deutsche Bank AG and Barclays PLC, say they buy only from banks outside the countries in which they are seeking protection.
Some analysts and investors say they had assumed that sovereign credit-default swaps, known as CDS, were primarily sold by giant global investment banks in the U.K., France and Germany, as well as in the U.S. Those banks sell the swaps to big corporate clients and other banks and institutions.
But the new EBA data show a surprising breadth of large and small European banks—at least 38 of them—have sold instruments that protect against potential losses on Greek, Irish, Italian, Portuguese and Spanish government bonds.
"There's a complex web," said Mike Harrison, a European banking analyst with Barclays Capital in London. "It's more dispersed than we had anticipated."
Of the total protection that European banks have written on government bonds in Europe's five most-stressed countries, nearly one-third originated from German banks.
Deutsche Bank was responsible for most of that, primarily due to its extensive corporate- and investment-banking businesses. As of Sept. 30, the Frankfurt-based bank had sold €37.4 billion of such protection and bought €34.5 billion.
Deutsche Bank executives say their positions are well-hedged and that they buy CDS protection only from institutions based outside the countries in which the bank is trying to buy protection. In other words, Deutsche Bank wouldn't buy Italian swaps from an Italian bank.
But, aside from Deutsche Bank, a handful of relatively small German lenders—part of a network of troubled public-sector lenders known as Landesbanks—also have been busy selling and buying such protection.
Among those is Landesbank Baden-Wurttemberg, which as of Sept. 30 had sold about €5.4 billion of CDSs tied to Greek, Irish, Italian, Portuguese and Spanish government bonds. It also had bought €4.1 billion of similar protection, giving it a net exposure of roughly €1.3 billion.
The holdings stem from a decision by LBBW, before the financial crisis erupted in 2008, to invest in southern European government bonds as a high-yielding and seemingly safe investment, according to a person familiar with the matter. In addition to buying the bonds outright, LBBW also sold the credit-default swaps to investors and clients. Because the swaps pay off if the bonds default, selling the swaps was a way for LBBW to build up a bullish position in the bonds.
The bank, which is restructuring its balance sheet after receiving a government bailout, is now reducing its sovereign CDS portfolio with the hopes of eventually eliminating it entirely, the person said.
The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It also means it is harder to predict how losses would ricochet among institutions and countries, analysts say.
The swaps have become a sort of political football as European politicians and bankers wrangle over how to resolve the continent's financial crisis. While debating whether private investors should bear losses on their Greek government bonds, for example, some political leaders insisted over the summer that any restructuring be tailored to avoid triggering payouts on the credit-default swaps, in part fearful of the unknown financial repercussions. At the same time, a growing number of European politicians have called for a clampdown on the instruments, asserting they are used primarily by speculators looking to profit from Europe's financial woes.
The banks and some analysts argue that the industry's actual exposure is far less than the €178 billion of swaps they have sold because the banks have purchased €169 billion in similar protection from other sources, which can offset the exposure. Many of Deutsche Bank's purchases and sales of CDSs, for example, are with the same counterparties, with whom the German bank has legally enforceable netting agreements in place.
But some experts say it is risky to assume that all banks' CDS transactions neatly cancel each other out.
"Netting is all very well provided that you trust your counterparty," said Jon Peace, a Nomura Securities banking analyst. But in a crisis situation, "what you thought was net could tend toward your gross exposures" because certain sellers of the default insurance could themselves go bust.
For example, two of Italy's biggest banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, have sold a total of about €5.3 billion of protection against the risk of an Italian sovereign default, according to the new EBA data. The problem is that, in a default scenario, both banks likely would be in trouble themselves due to their huge holdings of Italian government bonds and the fact that their businesses are largely concentrated in Italy.
The EBA information doesn't shed light on who bought the instruments from the Italian banks, although it does show that the two lenders also purchased about €4.2 billion of similar protection from other institutions.
read more: Olympus Wealth Management
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