Posts Tagged banks

Europe’s new credit crunch

Posted by George Irvin in EU on October 7, 2011

As the Euro Area (EA) dithers about bailing out Greece in the short term and continues to argue about how to expand the European Financial Stability Facility (EFSF), the sovereign debt crisis is turning into a full-blown banking crisis. Shares in Dexia, the Franco-Belgian banking group, are down 72% on their 52-week high—closely followed by other pillars of western finance such as Bank of America (-66%),  RBS (-57%) and Deutsche Bank (-50%). [1]  In effect, financial markets have seen the wiring on the wall and have been pulling out of bank shares—both banks that hold euro sovereign debt assets and those that hold shares in other banks that do. This means that the asset side of banks’ balance sheets are contracting and that insolvency looms.

True, the gloom lightened briefly when both Angela Merkel and EU President J-M Barroso announced they favoured a pan-European recapitalisation programme—causing EU bank shares to rally for a time. Governments are trying to pour cash into the banks—in the UK, Mervin King has announced an extra £75bn of quantitative easing (QE), allegedly to help industry get more and cheaper credit, but in reality to ward off a new credit crunch along the lines of what happened after Lehman’s collapsed in 2008. In his words, we face the ‘worst financial crisis ever’.

However, the recapitalisation of Europe’s banks faces a serious credibility gap. First, Dexia was one of the banks to pass the European Banking Authority’s (EBA) ‘stress tests’ with flying colours. Secondly, one result of these tests was a serious underestimation of the degree of recapitalisation required.  In consequence, a new round of tests will be required adding further to delays. Perhaps more importantly, there is growing pressure from investors to make banks ‘mark to market’; ie, report the current market value of their assets. Adoption of such a rule combined with current market volatility would doubtless lead to a large number of banks failing the stress tests.

And of course, the prospect of a Greek default looms larger by the day. The problem is not so much that a Greek default is unaffordable; doubtless, were the country to default on its own, it would take some banks down—starting with its own banks. The real danger is that of contagion. We know that Spain and Italy are ‘too big to fail’, and the markets have already begun to mark down commercial banks with exposure to them, not just in Spain and Italy but in France and even the UK. Whatever one may think about financial markets, their analysts are not fools; what they are telling us is that a Greek default will trigger widespread contagion.

Meanwhile, EA Parliaments dither about just how the EFSF’s limited capital can be stretched to meet the bill. Since the €440bn available cannot be miraculously turned into the €2tn required for ‘shock and awe’ to be sure of succeeding, the latest twist involves turning the EFSF from a lending institution into a insurance company, in effect selling credit default swaps (CDSs) to those most in need of insurance. These would be structured into equity, mezzanine and senior layers just like their Wall Street cousins, thus enabling €440bn to be hugely leveraged.

But as more than one commentator has pointed out, there are several problems here. First, one is using over-leveraged instruments to deal with the problem of over-leverage. Second, there is no ‘lender of the last resort’—if the scheme goes wrong, governments cannot bailout the losers since it is governments who hold the equity tranches. In principle, the ECB could perform this role—but the Germans are resolute in their opposition to the ECB acting as a Central Bank for governments. [2]  For that matter, tiny Slovakia is threatening to upset the EFSF applecart unless collateral is provided for its pledged assistance.

An obvious way out of this nightmare would be to forgive Greece at least half its debt (which the markets believe is in any case unpayable) while further reducing the interest on its loan, lengthening its debt maturity profile and aiding the country to become more competitive. Cynics might say this has been obvious from the start, and that it is now too late. If a European financial crisis does not happen next week, it will occur as part of a disorderly default in December when the pain finally becomes too much for Greeks to bear. It is then that we shall all feel the pain of a full-blown financial crisis, most probably followed by more years of economic recession.

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[1] See D Blanchflower ‘As bankshares tumble ..’ New Statesman, 10 Oct  2011.

[2] See http://on.ft.com/qi7ZIw

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Another banking crisis for Europe?

Posted by George Irvin in EU on January 26, 2011

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/

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