In March last year, while giving a re-cap of my concerns about the European financial situation, I stated:
National governments kept issuing bonds to cover the ever growing debt while the backing of the ECB was giving the false impression to foreign investors that Greece was as safe a Germany. So while Germany kept exporting into Europe other national governments kept spending to cover the difference. Those countries appeared safe and relatively cheap to foreigners so in rolled the capital causing asset driven speculation.
….
As soon as the EU was formed the fuse was lit, it was inevitable that economic stupidity, political opportunistic behaviour and corruption was going to lead to a collapse. But the real problem was that no one seemed be aware that once it did collapse the EU had no mechanism to deal with the fall out.
And that is the situation Europe finds itself in today as those asset pumping capital flows now attempt their flight to safety, either out of Europe or to its core, leaving peripheral economies as skeletons of their former glory.
The trouble was, of course, that those “foreigners” weren’t from the other side of the planet, in fact, the European banking system did most of the heavy lifting. Banking regulations within Europe supported this paradigm in which all sovereign debt was essentially risk free, and therefore equal. This setup a self re-enforcing mechanism in which the banks would lend to countries while at the same time purchasing sovereign debt as part of their capital base. This was a non-diverifed risk structure whereby national governments and commercial banks were tightly coupled.
When the economies were growing due to expansionary fiscal policy and excessive lending, everything was fine, but once the downturn occurred the weakness of sovereigns and/or their banks reinforced each other. As the financial world woke up to the fact that there was actually a spectrum of risk across Europe then banks in weaker sovereigns were punished. From then on it didn’t really matter which way the contagion occurred. If the sovereign became weaker then banks were exposed to that weakness, not just directly through asset quality via the weakening economy, but also through sovereign debt deterioration. This caused the bank’s stock to plunge, leading to the expectation of a bail-out, which weakened the sovereign … and around we go.
Just as the European system allowed for large capital flows into countries, it also allows them out. As the European crisis has worsened we have seen this occurring with deposits flowing out of the periphery banking systems into the core. The recent German bunds auction on negative real interest rates is also evidence that of that flight-to-safety. As I have talked about over the last few weeks, I suspect we are seeing this reflected in the interbank market, in which core banks are hoarding reserves while periphery banks are forced to use the discount window to re-coup reserves as theirs leak away.
This was the reason why back in August Christine Lagarde urged European banks to urgently seek more capital, even though Trichet and the EC eurocrats claimed it was unnecessary
The British Bankers’ Association (BBA) has thrown its weight behind a call from Christine Lagarde, head of the International Monetary Fund, for European banks to be forced to recapitalise to help prevent another financial crisis.
Fears of a sequel to the 2008 credit crunch are growing because of banks’ exposure to weak economies in the eurozone, where countries such as Italy, Spain and Greece are struggling to maintain international investor confidence.
Angela Knight, chief executive of the BBA, said that she agreed with Lagarde, who suggested at the weekend that European banks should be forced to accept capital injections.
Knight said: “I think she is right: some European banks should hold more capital as action is urgently required to stabilise the situation inside the eurozone.
The trouble now is, if Unicredit is anything to go by, the window of opportunity for periphery banks to raise new capital may have closed. This is a huge problem as Italian banks require an estimated 15.4 billion euros, along with Spanish banks at 26.2 billion euros. This includes capital shortfalls of 15.3 billion euros for Spain’s Banco Santander SA and 7.97 billion euros for Italy’s UniCredit SpA.
If it is the case that these banks cannot raise the required capital then they will have no choice but to shed assets, and fast. Failing that … well fail, placing even further burden on their host nations.
It is little wonder that the calls for the ECB to do ever more grow by the day.