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
Bad bad bad, what is really needed is the Swedish solution and put multiple banks in the public domain for the long term.
No bonuses, public sector pay grade 7e1.
All unhappy bankers get plane tickets to Greenland.
Yes, a Swedish solution would be preferable, because it would punish those who caused the mess. Sweden is even itself in the EU but has happily avoided the Euro so far.
No bonuses, public sector pay grade 7e1.
Yes, especially this aspect would take away the motivation for speculations.
I would suggest that before we race to “recapitalize” the banks, we first find out what the hard facts are for each bank. In their attempt to restore market confidence, both SocGen and BNP Paribas offered significantly more transparency into their exposures than had previously occurred.
I think we should follow the recommendation of the Chairman of BNP Paribas and have ‘utter transparency’ from the banks.
Once the market has had a chance to analyze the data, then a solution to the bank and sovereign solvency problems can be arrived at.
Without disclosure, simply recapitalizing the banks does not answer the question of who is solvent and who is insolvent. Without that question answer, as you pointed out with BofA, the issue of solvency comes back.
In 2009, it was Treasury Secretary Geithner’s pledge of the full faith and credit of the US to keep the 19 stress test banks solvent that “restored” confidence. It certainly were not the test themselves.
Agree 100%. Plus, you’re not going to get recaps quickly. You need to reassure markets in the meantime.
Thanks for the great post Ed!
1. Has the ECB committed to providing unlimited liquidity to its large financial institutions?
2. If so, doesn’t that take a Lehman style liquidity run off the table, especially if the ECB’s liquidity is not tied to Bagehot’s rule? May still be solvency issues, so capital will still be an issue, but isn’t a short-term liquidity run impossible?
“… 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…”
“The major central banks in the western world…”! This includes the FED. So the US FED is bailing out the European banks? “… at cheap rates and unlimited quantities …”?
Mr. Harrison: Your post “The European Bank Bailouts” mostly answered my question.
Question, how do you realize profit, when it was fraud, in the first place.
Skippy…as fraud was the multiplier, leveraged out the wazoo, in every direction, now collapsing inwards, back to trend, how do you bloody pillar vapors[????], inject more vapors?
how do you bloody pillar vapors[????], inject more vapors? Skippy
No. You forbid the creation of more vapors (so called “credit”) and then bailout out the entire population with real legal tender.
Skippy, they realized profit from the fraud when they realized they could profit from the fraud.
Answer: in cash, on the nail, and offshored in a wink.
Ultimately from loans, government subsidies, and IPO money. But cash and a government that compounds felonies.
Yeah I know many converted to value but, how do they sort the market. Electrons have so little weight yet they think increasing the delivery rate and volume will fix things.
Skippy…Scotsman engineer some where is losing his voice…croak…take…croak…more…thud. The captain really was a douchebag…eh…more, more, more yeah that will fix it, boom!
Thank you for distinguishing between a solvency crisis and a liquidity crisis, and, more importantly, putting them back together.
Several commentaries on banking including those who ought to know better, claimed banks weren’t insolvent, they’re just short on cash. The reality that the two are not muutally exclusive seemed to get lost in the howling.
I don’t know if the treaties creating the ECB and the EU allowed for resolution authorities, with or without raping the taxpayer to make speculators whole. If not, then the insolvency will probably trump the illiquidity and leadership will consist of letting the banks fall into the hole they dug.
Without the tax payer?
“We have a classic liquidity crisis on our hands, now not just for the sovereigns but the banks in Euroland as well.”
And I thought stupidly that most bank and the bank system as a whole were insolvent.
The Euro has plenty of room to fall against the USD. http://bit.ly/oYIfxA
The author’s dire scenario is quite plausible. Perhaps the situation is even worse: The European “have’s” are delaying the rescue plans needed as a game of “chicken” to coerce the “have-not’s” into quicker and more drastic austerity; then, like the Saturday movie serials of yore, as the bus goes over the cliff the heroes show up and snatch the passengers from the yawning abyss. This scenario has the “have’s” even more reckless than the article portrays and adds their delusion of being in control of being out of control. (Every very rich/powerful person I have ever personally encountered has had this affliction.) By way of contrast, I chanced into a counter-thesis upon watching a hyperactive stock tout (Jim Cramer) on TV today: Upon returning from Europe, Geithner assured Cramer that Europe most emphatically would not allow a “Lehman moment” to happen; Ben Bernanke has more tricks up his sleeve; gold is down, a sure sign of better times ahead; and Apple (tech corp.) stock is not only up but undervalued, another happy harbinger. (Methinks the fellow doth rant too much.) But then I remember that Jami Dimon said that we should expect a financial crisis every few years or so. As to Bernanke’s magic, Paul Volcker had a timely op ed in the NY Times yesterday discreetly warning that, since the Fed has pretty much shot its bolt and there isn’t much hope of rescue from the fiscal side, some at the Fed–unnamed–contemplate inducing a “controlled” inflation, of 4-5%, in the hopes of stoking the “animal spirits” a la Keynes. Volcker says that the contemplated cure would make the patient sicker; he even names “stagflation.”
“Methinks the fellow doth rant too much.”
I don’t mind rants, if the ranter is right. The problem with Jim Cramer is that since the economic tide began to ebb four years ago, he has been consistently WRONG.
Sample quote from March ’08: “Bear Stearns is fine!”. A week later Bear was flattened.
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.
How are the banks going to attract this money if the SNB insists on keeping its currency pegged?
I wonder too who would be that gullible to invest in those banks. Well, maybe governments are ready for it but it would be a disaster for tax payers.
Apparently the ECB has become the latest regional Fed bank. Of course, some of us would like to know why the US Fed has taken on this role. That’s a rhetorical question. The answer is, as always, to keep the looting going, not to fix anything. The Fed currency swaps are just more extend and pretend for the banks of the core. All of the problems that exist in the periphery are left completely unchanged by this program. But it says a lot about the weakness of the banks in the core and the lack of any effective European leadership that this Fed interventon was needed.
The eurobanks in the core are zombies. They are insolvent. Their liquidity problems are secondary to their insolvency. But like zombies they are permitted by corrupt political elites to keep functioning. They do this by cooking their books. The problem here is that until you do forensic audits of them you can’t say for sure how much it would take to recapitalize them. Recapitalization is only part of a needed reorganization. Throwing out bank managements, prosecuting them for theft and fraud, introducing personal liability to management, and turning banking back into a plain vanilla utility are first steps.
There remains the question of the euro. You either need a real fiscal and monetary union with a real central bank supervised and accountable to a democratic parliament or you need to break the euro up.
And the question of trade. Germany and the north can not be allowed to continue its mercantilist trade policies against the rest of Europe.
A final note: a thought experiment. If it would take 127 billion euros to capitalize the big German banks to 5% and say they are at about 3% now, then that 127 billion is about 2% of what they have on the books. Now banks that crash and burn in this country and are resolved by the FDIC generally have loan losses in the 40% range. That’s 20 times the 2% valuation or around 2.5 trillion euros or around $3.5 trillion. You can vary the parameters but this gives you the ballpark. The real question here is who should be taking the big haircuts on this. As Europe is a kleptocracy, it is pretty clear who should (the rich) and who will (ordinary Europeans) are quite different.
I agree. You are on the same page. First step must be to make those looters accountable. Once they know they cant get away with the loot, and only then, they will stop.
Watching Greece is like observing a horse with two broken legs. You anxiously await for somebody to show up and put her out of her misery.
Will there ever come a time when a system is failing the reasons for its failing will be investigated and the option of a different system taken? Or will it always be bail out the culprits and capitalize the banks and banking system that has not worked. The world is becoming a mess those running the financial systems are not doing a very good job but we keep them flush with cash so they can screw the public. Is it too late in our evolution as a system to expect anything different? I am starting to think the fix is in everywhere and there is unlimited supplies of cash for the banks and players in finance but not enough to balance the budget.
We are in the wait it out stage in the US and it is not doing well for many. And now we will be getting blown for for the next year and half by those seeking re election. Nothing will get done and laws will not apply to corporations and their executives but it will be more heavily applied to everyone else.
_We need to recapitalise European banks_
Is that the royal WE? Because I’ve done all the recapitalizing I can take.