Cross-posted from Credit Writedowns
This past weekend the German-language newspaper Frankfurter Allgemeine Zeitung (FAZ) wrote an article centered on a report by the Deutsche Institut für Wirtschaftsforschung (German Institute for Economic Research). The report claimed that the German banking system was undercapitalised by 127 billion euros. Reuters reported on this briefly but I have yet to see any further details in the English-language press.
Here’s how the FAZ article begins (hat tip Alex; my translation):
This should be a real coup. The major central banks in the western world came together last Thursday to announce they would make dollars available for European banks to borrow – at cheap rates and unlimited quantities. Previously dollars had become especially scarce for French banks because American money market funds no longer trusted them.
The joint action by central banks was to show that we are willing to do anything to save our banks to prevent them running out of money. But it also shows that in the European Central Bank and in the banking world, there is great uncertainty. The increasingly difficult rescue of Greece, the angry departure of EU and IMF inspectors, the utterances of the German economics minister, who no longer denies the possibility of Greece’s bankruptcy – all this has ensured that in Europe it is no longer just about whether Greece is now paying back his debts or not. The Greek crisis has become contagious. And it has infected the heart of the European financial world: banks.
Unfortunately, this is true. We have a classic liquidity crisis on our hands, now not just for the sovereigns but the banks in Euroland as well. I would consider this a bank run via the wholesale funding market – exactly what we saw with Northern Rock, Bear Stearns, and Lehman Brothers. At the beginning of last month, when the contagion from Greece had spread to Spain and Italy I said this is a classic liquidity crisis and suggested the ECB had to step in or it was game over. They have provided some liquidity but they fear they have moved fully into a fiscal function, resulting in the resignation of two German ECB officials. Meanwhile, on the fiscal front, dithering by European politicians continues and so the infection has spread to the banks.
We are at the culmination of a long-term debt cycle that ends in deleveraging and debt deflation, something Ray Dalio calls the D-process. I highlighted the thinking of Ray Dalio on the D-Process in Europe and wrote that “I see credit writedowns in the financial sector as the central element linking financial system fragility with the underlying economy. and will have more on this in an upcoming post.”
Let me say just a little more on that here. Since banks are at the heart of our credit-based financial system, when they suffer existential liquidity constraints, it feeds quickly into the real economy via the reduced credit availability that leads to lower economic output and recession. So, clearly we are at a fragile point in this part of the crisis. In the US, after the subprime trigger in 2006 and 2007, the credit crisis infected the banks and led to recession by December of 2007. The sovereign debt crisis in Europe is creating the same kind of dynamic again, this time with Euroland at the center of action.
One commenter on my post about the ‘coordinated’ central bank action wrote something I largely agree with here.
I always wonder as to why "contagion" happens in the EU case. The contagion itself is market driven, and thus subject to panics. And the markets, specifically during the month of August, are driven by low volume and can be ‘manipulated’ by a few dedicated hedgies. I consider this panic largely manufactured, feeding on the scars of 08 still fresh in people’s mind, driving the banks to a Lehman scenario in the imagination of people. The leap of faith the analysis does is always this ‘contagion’ part (Ed you do it too). Except as we all point out, the euro rolls are all in place and the dollar ones are already there and functioning. Personally I put my money (literally) on market manipulation.
I am not convinced the banks at the center of this liquidity crisis deserve to be shut out of commercial paper markets. So, no I don’t “do it too”. This could well be just a liquidity crisis and not a solvency crisis for the French banks. But this is a panic; and right now for investors its all about preserving capital. That means shunning the weakest debtors.
Here’s what’s happened to bring about the European Bank Bailout:
- The structural deficiencies of the eurozone have led to a panic that is similar to the liquidity crisis we witnessed after the subprime meltdown in the US, creating funding difficulties for European financial institutions.
- European banks are particularly undercapitalised. It is worries about the solvency of these banks in the event of a sovereign debt default in the euro zone which has created what should be considered a bank run via the wholesale funding markets.
- Banks are engaged in risky activity which makes their undercapitalisation that much more worrisome. The losses at UBS underscore this last point.
It was only when the US banks were partially recapitalised in 2009 after the stress tests that the panic ended. And even so, partial recapitalisation means nagging doubts about the health of some institutions like Bank of America persist. If the US economy double dips, you should expect those doubts to increase and the doubts to spread to other institutions. The right thing to do is to accept the bitter pill and make substantially all of the credit writedowns at financial institutions quickly and recapitalize and/or nationalize the weakest banks. That means default for Greece and likely for at least 1 or 2 other sovereign debtors accompanied by a simultaneous injection of capital. This prevents the nagging doubts about the solvency of financial institutions. Instead what politicians try to do is bail out the banks with liquidity and ride it out.
Here’s the problem as described by the FAZ that is creating the liquidity crisis – and this problem is real, not manufactured:
The U.S. bank Goldman Sachs has calculated that the 38 largest European financial houses need a total of 30 to 92 billion euros in additional capital to withstand a medium-sized shock to government bonds. The head of the International Monetary Fund (IMF), Christine Lagarde, is even more pessimistic – which is alarming because, as former French finance minister, she knows European financial institutions particularly well. Europe’s banks desperately need money, she warned recently – so urgently that the politics may require a cash injection by force if necessary. € 200 billion is lacked by the banks, IMF economists have calculated, according to an internal document. These are all "preliminary results", Lagarde said, shortly after the number was leaked to the public. But that did not quite calm markets.
Dorothea Schäfer of the the German Institute for Economic Research (DIW) even fears that the IMF figure is still too low. In order for banks to hedge against crises of this dimension, they must increase the ratio of equity to total assets at least five percent, she argued. She worked out for this newspaper what that would that mean for the ten largest German banks which participated in the stress test: 127 billion euros of additional capital would be needed.
The bottom line for me is two-fold
- We need a credible solution to Europe’s debt crisis and that means defaults must occur sooner rather than later. The euro is too restrictive to allow sovereign debtors to grow their way out of their liquidity crisis. Austerity will cause economies to contract and debt to grow, meaning that even after budget cuts and tax increases the eurozone periphery will still not be able to lend at rates which would reduce their debt burdens.
- We need to recapitalise European banks. The UBS incident shows how easy it is for large and opaque banks to lose billions. Switzerland is on the right path in forcing their banks to increase capital levels substantially. Twenty-percent equity capital is a figure now being bandied about.
Unless we get both hard restructurings and more bank capital in Europe, the crisis will continue to get worse.
Source: Bankenrettung: Wieder muss der Staat ran – FAZ