It’s fitting that it is an Italian who has been charged with reshaping the landscape of the European banking system. The first financial institutions came into being among the rolling Tuscan hills, and the most high-profile casualty of the recent ECB stress tests was the world’s oldest bank, Banca Monte dei Paschi di Siena.
Mario Draghi, president of the European Central Bank, has shown remarkable single-mindedness in his determination, as he famously phrased it in a 2012 speech, to do “whatever it takes” to preserve the euro. Necessarily, this ambition has centered upon scouring the balance sheets of the euro zone’s banks. Within five weeks of his appointment as president in 2011, Draghi had implemented long-term refinancing operations (LTROs), the loan programs that sought to end the negative feedback loop between euro zone sovereigns and banks.
With the first part of his mission accomplished — European sovereigns are no longer being dragged down by their wayward banks — Draghi has now embarked on the second phase of the lengthy, and often painful, process of resuscitating the continent’s moribund financial system. “It is like a wound that needs to be disinfected immediately,” he said in a recent interview. “Although there may be some more loss of blood, once it has been properly taken care of the illness will disappear. The banks will return to lending in a much more robust position.”
One of the criticisms of the two LTRO programs that took place in late 2011 and early 2012 was that relatively little of the more than €1 trillion ($1.2 trillion) drawn down found its way into the wider European economy, with banks choosing to horde the cash on their balance sheets rather than increase their lending. Now that the dust has begun to settle on the yearlong ECB stress tests, Draghi has initiated a new series of measures — the TLTRO (the “T” stands for “targeted”) and ABS (asset-backed securities) programs. The former is a more strategic effort to ensure that liquidity feeds through the banks to European corporations; the latter is tasked with purchasing ABS assets currently on bank balance sheets. These measures are of central importance to Draghi’s vision of the new, financially sound euro zone.
These most recent interventions are specifically designed to stimulate European inflation. In listening to Draghi’s speeches over the years, the possibility of a Japan-style deflation in the euro zone emerges again and again as the worst of all possible outcomes. When he announced the TLTRO and ABS programs in June, Draghi said they were aimed at getting inflation expectations back up, a point he reiterated four times at his October 2 press conference.
The current low-inflation environment is threatening to move into a more drastic phase, with seven countries (including Italy and Greece) already in deflation and the overall rate for the 18-nation area sitting at a paltry 0.3 percent. The LTRO and ABS programs are desperately needed, and although an acronym-weary market has been focused more on the stress test results, these measures are arguably much more important and should provide a way out of the deflationary hole into which much of Europe has fallen.
We at GLG have recently moved overweight in European banks in both our European and global portfolios. Our change of heart (we had been underweight for the vast majority of the past eight years) has been prompted by the determination and logic we find in Draghi’s approach to addressing the problems facing the European financial system. We believe that the market has underestimated the potential size and impact of the ABS program in particular. These latest interventions will drive a substantial improvement in European banks’ overall profitability, and their return on equity specifically. Considering that the market seems to have given up on European banks (and on broader prospects of European growth), we find outstanding value in the sector, which is trading at book value.
Although we are in a minority, we also believe that the TLTRO and ABS programs will have a positive impact on bank lending. The counterargument is simple: There is no demand. Although this has been true in the past, we think demand for loans is now emerging among European corporations. The ECB’s own lending survey has shown positive net demand for credit in the past three quarters. The road to European recovery will be a rocky one, but we believe that (most) banks have already taken (most of) the pain and that inflation will, eventually, return.
The overriding point is that Mario Draghi is on a mission to raise inflation expectations, and he appears willing to do almost anything to achieve this. In financial markets that can often seem anonymous and abstract, it’s a salutary example of a single individual making a real difference with a coherent, convincing vision. • •
Ben Funnell is lead portfolio manager of the GLG Euro Equity and Global Equity strategies and of the GLG Balanced Managed strategy.
