Just when you think the European crisis cannot get much worse, Wednesday’s shunned Bund auction showed that it can. With this, the risks for the global economy as a whole, and for virtually every country, increase materially.
Given this week’s developments, there should be no doubt in anyone’s mind that what started out as a dislocation in the periphery of the eurozone has now decisively breached the firewalls protecting the outer core and is seriously threatening the inner core. Unless this is countered quickly, European policymakers will find it even harder to catch up with the crisis, let alone get ahead of it.
Europe must still stabilise its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.
In the eyes of the markets, the capital cushion of Europe’s banking system as a whole is no longer sufficient to support its balance sheet. This concern is not limited to the markets. Judging from their eagerness to dispose of assets, bank managements also believe that balance sheet delevering is key to the institutions’ survival and wellbeing.
In today’s environment, selling begets more selling; and it is not just about other unhealthy balance sheets also being forced to delever. The vast majority of healthy balance sheets -fortunately there are still a few - are reluctant to engage. Some are even taking risk off further, including those that believe that this enhances their relative market standing. It brings to mind the period of ”macho provisioning” by US banks during the Latin American crisis of the 1980s. Ironically, this may be intensified by Tuesday’s announcement that the Federal Reserve will impose another stress test on large American banks.
None of this helps liquidity management. Not surprisingly, a growing number of European banks are now either materially or wholly dependent on the European Central Bank and related facilities (such as the national emergency liquidity assistance programmes). The situation is particularly acute for those that previously relied on wholesale funding, which has essentially disappeared, and those suffering deposit outflows, which are accelerating in very troubled countries such as Greece.
All this makes it very hard for the banking system to get back on side quickly, especially at a time when three other issues are making it difficult to manage balance sheet risk. First, traditional asset diversification no longer affords the same degree of risk mitigation given the scope and scale of the European crisis. Second, with historically low interest rates on government bonds issued by the strongest economies, such holdings offer only limited protection in today’s environment. Third, confidence in market-based hedging instruments, including credit default swaps, is eroding due to uncertainty about what will happen to them during major market dislocation.
Problems in the banking sector have a nasty habit of accelerating and amplifying crises. Indeed, they significantly increase the risk of policymakers losing control. It is therefore critical for Europe to add this policy challenge to an already long ‘to do’ list.
Europe must now go well beyond the steps proposed at the October 26 summit. In addition to specifying higher prudential capital ratios, governments must now bully banks to act immediately. Where private funding is not forthcoming, which should now be the presumption for a growing number of banks, recapitalisation must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared.
The urgent stabilisation and reform of the banking system is one of the five key areas that will determine the future of the eurozone. With little time to waste, success will also require progress on the other areas – namely, more appropriate reform programmes on the part of heavily-indebted economies, a better delineation between solvency and liquidity cases, more effective circuit breakers from the ECB, and decisions on the urgent strengthening of the institutional underpinning of the eurozone (as currently configured or in a smaller version).
Europe’s already long list of ‘must do’s’ is getting longer and harder by the day. Denial, obfuscation and further dithering by policymakers serves only to make the situation even more daunting, and the eurozone’s future more uncertain.
The writer is the chief executive and co-chief investment officer of Pimco
Eurozone sovereigns must be stabilised before the banking sector
Europe’s dance of death between sovereigns and banks has now turned frantic and much more dangerous. Troubled countries, such as Italy and Spain, continue to weigh their banks down. Growing problems in French, Cypriot and Belgian banks are putting pressure on the countries.
As Mohamed El-Erian argues, action is needed on multiple fronts to stem the worsening crisis but I don’t fully share his priorities.
Fact is that no amount of capital or funding support for Europe’s banks will be enough to restore confidence so long as doubts remain about the solvency of Spain, Italy and other eurozone economies. With borrowing costs at almost seven per cent, the two large countries may soon face a debt snowball – particularly as austerity measures push the region into deep recession.
Given the worsening economic outlook and the institutional and political gridlock in the European Union, almost everyone expects the economic situation to worsen. In the absence a clear political endgame and more substantial economic support from European Central Bank, there is no visibility on how bad the economy could get. Irresponsible talk of a possible break-up of the eurozone, only adds fuel to the fire.
Unless borrowing costs for sovereigns are brought down to sustainable levels first, most policy measures to strengthen EU banks would be ineffective and may even backfire.
The best, and perhaps only, way to provide credible sovereign support would be for the ECB to set a yield target of four to five per cent for illiquid, but solvent, sovereigns, such as Spain and Italy. This is also necessary to repair the broken transmission of monetary policy and enable the banking system to restart the flow of affordable credit to the real economy.
Even with lower borrowing costs, the eurozone’s most indebted countries could be faced with unsustainable debt levels as economies shrink sharply under the weight of austerity measures. Policymakers must use the economic space provided by any additional ECB support to slow down deficit reduction programmes in troubled economies, trigger stimulus spending in healthy economies and embark on a growth-enhancing infrastructure projects financed by a doubling of the European Investment Bank’s callable capital.
Greece’s problems meant that EU policymakers prematurely shifted their focus away from the still-unresolved problems in the EU banking sector. Now those endemic capital and funding problems faced by financial institutions have resurfaced at a critical juncture. The kind of sovereign funding guarantees and recapitalisations that pulled EU banks back from the brink before are simply not possible now, particularly for banks in troubled sovereigns that most need such support.
In fact, asking countries such as Spain and Italy, at this point, to guarantee bank funding and provide capital backstop will not just be ineffective but would actually worsen the already fragile sovereign credit. The repeated rejection by eurozone leaders of proposals for providing pan-European funding guarantees and capital support has meant that the dance of death between countries and banks has become increasingly frantic.
I am not arguing that EU banks don’t urgently need more capital and access to unsecured funding, they clearly do. But they have lost access to sources of funding for two main reasons. First, the possibility of incalculable losses due to their exposures to various eurozone sovereigns. Second, the increasing potential losses on their holdings of private assets in deteriorating eurozone economies. No one wants to be exposed to banks that can lose so much money.
ECB support for countries will instantly minimise the first. Growth will significantly reduce the second. This will reopen access to private funding and capital markets, as EU banks would cease to be seen as bottomless wells.
Policies such as a two-year moratorium on bonus and dividend pay-outs, an European Financial Stability Facility-backed bank capital backstop and a EFSF-backed term funding guarantee will put the eurozone banking system back on its feet. However, this will only work if all doubts about the solvency of the sovereigns have been put to rest for good.
The writer is managing director of Re-Define, an economic think tank, and a visiting fellow at the London School of Economics