There has been some positive news on the banking industry recently. 84 out of 91 banks passed the EU stress tests and UK banks posted much improved half yearly profits. Sovereign debt fears for ‘Club Med’ countries have receded from the headlines. We should not however forget that governments around the world ran up trillions of dollars of debt over recent years and that banks also owe trillions. Where is all this debt? To what extent are the institutions holding your money exposed to it?
According to estimates from the Bank for International Settlements, almost $5 trillion (€3.88 trillion) of debt is due to be repaid by banks through 2012. When they come to refinance these loans they will have to compete with governments also looking to refinancing their debt.
Around $2.6 (€2) trillion of these liabilities are in Europe, where the banking system is already burdened with the sovereign debt crisis. There are question marks as to how the banks will be able to come up with the money.
A July report by Standard & Poor’s said that European banks had amassed €30 trillion in liabilities and warned that their collective funding needs are “vast”, with large repayments falling due in 2011 and 2012.
Government and central bank funding and liquidity support has been crucial for many financial institutions in Spain, Portugal, Ireland and Greece and the industry, particularly second tier banks and fragile institutions, faces financing risk over the medium term as the funding and liquidity support ends.
Using European Commission statistics, S&P estimates that the amount of government guaranteed commercial debt outstanding was approximately €1 trillion on 30th June 2010. It calculates that this represents 15-20% of the outstanding debt securities of European banks at present.
According to the Bank of England’s June Financial Stability Report, UK banks need to replace between £750 and £800 billion (around €940bn) in long-term funding by the end of 2012. This is an average of over £25 billion per month – more than double the £12 billion raised between 2001 and 2007. The BoE acknowledged that raising all this funding will be a “substantial challenge.
The European Central Bank’s Financial Stability Report in May had warned that Eurozone banks are facing a “second wave” of writedowns, of up to €195 billion over the rest of 2010 and 2011. This is on top of the €238 billion written off in bad debts by the end of 2009.
And then there is sovereign debt. There is a considerable amount of outstanding government debt issued by Portugal, Ireland, Italy, Greece and Spain (the ‘PIIGS’).
At the beginning of May total outstanding debt for these five countries was estimated at $3.9 (€3) trillion, with $600 billion due to be repaid in the following 12 months and $2 trillion over the next three years. Italy had the largest debt at $1.4 (€1.09) trillion, followed by Spain with $1.1 (€0.85) trillion.
This is a staggering amount of debt. For those who have problems comprehending the size of a trillion (and who doesn’t?), if you had spent a million dollars a day since the year zero, you still wouldn’t have managed to spend a trillion.
These are not just short term concerns. Ratings agency Moody’s warned that the world has changed since Europe’s debt crisis and none of the large sovereign states can still assume it is credit worthy. In its quarterly Sovereign Monitor it said: "Genuinely adverse debt dynamics were only expected to materialise in 15 to 20 years. The crisis has 'fast-forwarded' history, eroding all the time available to adjust."
Comparing the debt spike to that which followed the Second World War, young economies then could outgrow their debt burden but this time the threat lies ahead – aging populations are driving up pension and health care costs for governments on a static tax base. “While the current stock of debt is large, it is dwarfed by the accumulation of future liabilities if policies do not change.”
In July the market was pricing in losses on Greek debt of about 60% and there is a fear that it could lead to contagion with other markets. The problem for savers and investors is that it is virtually impossible to ascertain fully which institutions are exposed to potential losses on PIIGS debt; what impact this would have on their balance sheets and the consequent impact on your money.
There is an additional problem to consider. It has been revealed that a number of institutions have been holding client assets on their own balance sheets, exposing clients to losses if the institution had got into trouble. JP Morgan Securities received a record £33 million fine from the UK Financial Services Authority for failing to segregate clients’ cash balances from the main funds of its parent JP Morgan Chase Bank. The amount varied between £1.3 and £15.7 billion over a seven year period. Had the firm become insolvent, the funds would have been at risk of loss.
Margaret Cole, the FSA director of enforcement and financial crime, said that “we have several more cases in the pipeline.”
Under such market conditions you need to be cautious as to your choice of institutions to hold your assets.
After thorough research my firm has established that the jurisdiction which offers complete clarity is Luxembourg. Due to the investor protection regime operated there, we can be certain that assets held in a Luxembourg life assurance bond are not at risk to institutional exposure to sovereign debt. Client assets are held by third party bank custodians in separate custodian accounts and there is close monitoring by the Luxembourg regulator. In the event of the failure of a bank custodian due to exposure to PIIGS debt, clients are safeguarded.
An insurance company which operates on a purely unit-linked basis (assets and liabilities are always equally matched) would provide you with further safety.
Note that this structure provides for protection against institutional loss and not investment losses on underlying assets as a result of losses on PIIGS debt. Your portfolio should be adequately diversified to reduce investment risk.
For advice on asset protection and reducing investment risk, speak to an established and qualified wealth management adviser such as Blevins Franks.
By Bill Blevins, Managing Director, Blevins Franks
19th August 2010