We tend to forget that sovereign debts crises and banking crises are merely two sides of the same coin. At the end of 2009, for example, consolidated claims of French and German banks on the four most vulnerable members of the Eurozone were 16 per cent and 15 per cent of their GDP, respectively. For European banks, as a group, the claims were 14 per cent of GDP.
In the words of Martin Wolf, ‘any serious likelihood of restructuring would risk creating sovereign runs by creditors and, at worst, another leg of the global financial crisis.[1]
Since 2008, the main difficulties for financial institutions have been in the UK, Germany, the Benelux countries and Ireland. Although the exact nature of each institution’s problems varied, broadly the difficult was a shortage of liquidity in the banking system. The Irish problem of extending a blanket government guarantee for a mountain of private bank debt is well known. In Germany and The Netherlands, names like Hypo and Fortis spring to mind. But what of all that shaky sovereign debt held by EU banks? As the ECB rcently warned, Eurozone banks will face refinancing needs of €1000bn over the next two years.[2]
To understand this problem, have a look at a new piece by Professor Mark Blyth of Brown University in the US. Speaking of the European crisis, Blyth says:
What was a crisis of banking became, in short order, a crisis of state-spending via a massive taxpayer put, and with sovereign bondholders’ interests being held sacrosanct while their investments were diluted (if not polluted), the taxpayer had to shoulder the costs twice: once through lost output and new debt issuance; and then twice through the austerity packages held necessary to placate the sovereign bondholders.[3]
Blyth goes on to point out that too little attention has been paid to the role of Europe’s banks, who in the past two years were happily dumping northern states’ sovereign bonds for high-yield Club Med bonds. But private actors will want to hedge their positions, buying equities, real estate and the like. A problem arises when these markets go south, leaving banks holding risky bonds with little cover. Their only option is to ‘dump good to cover bad’—but if all players do so together, the strategy yields perverse results. If I know you’ll dump Greece, I’ll dump Ireland, and you’ll then dump Spain to stay ahead of me, so I’ll dump Italy and so on.
With everyone trying to go liquid, liquidity suddenly becomes nearly impossible to achieve. As Blyth says, you can keep passing the ‘put’ around, but there comes a time when somebody has to pay up. The taxpayer cannot pay forever (because he or she is or soon will be on the dole), and the EFSF is just a special purpose vehicle with little cash and much rhetoric about which bondholders have grown deeply cynical.
There’s a limit … and it’s called Spain. Spain’s government and private bonds are held by banks all over Europe. Spain is ‘too big to save’. Blyth concludes that the Germans know this—their theatrical rhetoric is merely designed to postpone the mother of all bank runs.
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1 See http://www.ft.com/cms/s/0/0c382c9c-0237-11e0a40-00144feabdc0.html #axzz1C2vbemOj
2 See http://www.ft.com/cms/s/0/6dba1338-03ac-11e0-9636-00144feabdc0.html #axzz17y7ZYFDz
3 See http://crookedtimber.org/2011/01/18/the-end-game-for-the-euro-german-rules-and-bondholder-revolts/
