LOS ANGELES, December 20, 2011 – The cracks in the banking system of the Eurozone are beginning to widen, and it seems as if every day something new happens, or some little tidbit gets revealed that seems to indicate that the whole contraption based on a common currency is about to come unhinged. Credit Agricole has recently announced that it will fold up its investment banking services in 21 out of the 53 countries in which it does business, and Commerzbank of Germany may well be getting a capital injection from the German government in the coming days.
According to a recent study by Kenneth Rogoff and Carmen Reinhardt, sovereign crises go hand in hand with banking crises. Their research indicates that, after a banking crisis, public debt increases on average by 86 percent, and this is only central government debt; if we take into account local government debt, GSE debt, and public guarantees of private debt, the figures become hazier, and much higher.
The “core countries” in Europe (France, Germany, Austria, and the Netherlands) have sovereign balance sheets that look relatively healthy, especially when compared to the U.S. or Japan. But if Reinhardt and Rogoff are to be believed, one cannot judge the relative solvency of this or that country without looking at their banks, and European banks are about three times as big as American banks (relative to their economies) and twice as leveraged.
In the U.S., after the financial crisis of 2007-2008, Washington force-fed capital into our banks, usually against their will. As a result, American banks today may be overcapitalized. The Europeans, on the other hand, have yet to fortify their banks, as the U.S. did, on a national scale. Instead they waited until 2010 when Greece began to knuckle under, and then they decided to apply a remedy of half measures. First they deemed the sovereign debt crisis a “liquidity problem,” and mustered a bailout to treat the immediate symptoms. Then they conducted a series of stress tests to convince the market that their banks were sound and safe. The first stress test failed only 7 banks, most of them Spanish, and amazingly the amount of new capital needed was deemed to be a mere 3.5 billion euros. The next stress test changed the figure to 2.5 billion euros. Then, just this month, the number jumped to 114.7 billion euros, a meteoric rise from 2.5 billion, but still considered by many to be insufficient.
The market is not waiting to find out how much capital will restore the banking system to health. With each passing day, it is becoming more and more apparent that a silent yet inexorable run is taking place against the banks of Europe. Those on the periphery are losing deposits fast, and as a whole the Eurozone banks have had their wholesale funding cut off, meaning that today they are relying almost wholly on the ECB for liquidity.
Before this financial tsunami hit Europe, all of the core countries’ banks had purchased the sovereign debt of the PIIGS, believing that they were risk-free, as they were denominated in euros. Now these supposedly risk-free assets have morphed into ticking time bombs, and the core countries’ banks are selling them fast. The ECB is stepping in to buy and so are the host country banks, especially the Greek and Italian banks, under heavy pressure from their governments.
Saving Europe obviously has taken a back seat to saving one’s own banking system. The core countries are gambling that they can flush their banking sector of the ticking time bombs before they start to explode. That was the whole idea behind the Greek bailout. The Germans and the French forbid the Greeks to default not because of any special concern for Greece but because a Greek default would cripple their own banks. The 110 billion euros accorded to Greece in May 2010 was designed to build a firewall around Greece so that the rest of Europe would have time to do what they are doing now – pare down the bad debt and hopefully recapitalize. They were betting that in the meantime the debts of the other PIIGS would not be overly affected. But yields on PIIGS debt have since then soared, and today there is a significant risk that this fire sale will drive down the value of the bad assets faster than the banks can get rid of them. It is a bit like bailing water from a sinking boat, while the holes get wider and wider.
So what can the Europeans do? In my opinion, the ECB must give a blanket guarantee to the major European banks so that the states can gain some breathing space to recapitalize those banks as they see fit. Relying on the EFSF is passé. The EFSF is only as good as the guarantees of its guarantor states, and when one of the guarantors, Italy, suddenly looks like it needs to be guaranteed, how can the fund be trusted? It is no surprise that the Europeans have failed as of yet to raise the fabled 1 trillion euros that they believed would calm the markets. Three times this year, the EFSF issued bonds with a total face value of around 13 billion euros and, each time, yields were higher and subscriptions lower. The only measure that will have a palpable impact is a demonstration from the ECB that they will provide a direct flow of capital to the banks. In short, only the massive and indiscriminate use of monetary policy can save the day.
In 2008, only the combined power of the Federal Reserve and the Treasury was able to stop the financial tsunami from destroying America’s financial system. Today we are asking the Europeans, who have already given up control over monetary policy, to this time give up control over fiscal policy and at the same time solve a banking crisis and a sovereign debt crisis. This is a much, much harder challenge than the one that was presented to us in 2008.
The solution I have proposed here is not a comprehensive fix but another kick of the can, another attempt to delay the inevitable. By no means is it a solution to the underlying problem, which is the staggering amount of debt that we, the developed nations, have managed to accumulate in the past decade. According to a study done by Hayman Capital, total global debt, public and private, has increased at a compounded annual rate of 11% since 2002, compared to a rate of 4% for GDP. Global debt is now over 300% of world GDP – the highest in recorded history. Not even the wealthiest countries in the world can go on like this forever without either restructuring their debts or taking painful measures to reduce deficits. All must eventually submit to the force of gravity.
 Though it is clear that European banks are larger (relative to their economies) and more leveraged than American banks, it is important to note that different accounting standards (US GAAP vs IFRS) make a direct comparison between the two systems difficult. IFRS does not allow derivative positions to be netted, while US GAAP does, and this tends to overstate the assets of European banks.
 Individual banks have been recapitalized. For example the German government already owns 25% of Commerzbank. However, there has not been a nation-wide recapitalization in any of the European countries. The exception is Great Britain.
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