Europe's Tottering Banks

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Includes: FXE, HSBC, UBS, VGK
by: Acting Man

'Coming Clean'

Reuters reports that "Europe prepares to come clean on hidden bank losses." Prepares to come clean? You mean, it hasn't come clean yet? And what "hidden losses"? Readers may recall the farcical stress tests by the European Banking Authority over the past few years, which evidently failed to uncover what the true state of the banking system was. We still recall that Dexia was given a clean bill of health as one of the "best capitalized banks in Europe" a mere three months before it failed and had to be bailed out.

In addition, keep in mind that commercial banks in places like Spain and Italy have loaded up big time on the debt issued by their governments, so that the often invoked "breaking of the nexus between banks and their sovereigns" has definitely not happened. The exact opposite has in fact occurred. Meanwhile, there seem to be a great many toxic assets still rotting in the closets where the skeletons are habitually kept. The Reuters report highlights what a gigantic farce this still is by noting that "nobody knows how big the losses are":

Euro zone countries will consider on Monday how to pay for the repair of their broken banks after health checks next year that are expected to uncover problems that have festered since the financial crisis.

Nobody knows the true scale of potential losses at Europe's banks, but the International Monetary Fund hinted at the enormity of the problem this month, saying that Spanish and Italian banks face 230 billion euros ($310 billion) of losses alone on credit to companies in the next two years.

Yet five years after the United States demanded its big banks take on new capital to reassure investors, Europe is still struggling to impose order on its financial system, having given emergency aid to five countries. Finance ministers from the 17-nation currency area meeting in Luxembourg will tackle the issue of plugging holes expected to be revealed by the European Central Bank's health checks next year.

The president of the European Central Bank underscored the need for action in Washington at the meetings of the International Monetary Fund and the World Bank.

"The effectiveness of this exercise will depend on the availability of necessary arrangements for recapitalizing banks … including through the provision of a public backstop," Mario Draghi said on Friday. "These arrangements must be in place before we conclude our assessment," he said.

But the ministers' talks face an additional hindrance because Germany's finance minister, Wolfgang Schaeuble, is not expected to attend the two-day Luxembourg meeting. Germany, Europe's biggest economy, in talks to form a new government.

During the region's debt turmoil, the European Union conducted two bank stress tests, considered flops for blunders such as giving a clean bill of health to Irish banks months before they pushed the country to the brink of bankruptcy.

(emphasis added)

So the bailout mechanisms will be put into place before the ECB even looks underneath the first stone. Brilliant. If there is a € 230 billion hole in the balance sheets of Spanish and Italian banks alone per 'IMF estimate', then the losses across the entire euro-zone must be absolutely staggering (keep in mind that such estimates as a rule turn out to be hopelessly overoptimistic).

The markets have become fairly unconcerned about euro-land banks of late, no doubt due to the recovery in peripheral sovereign debt and the fact that current account deficits have largely disappeared - which is obviating the need for foreign financing. Even though the Euro-Stoxx Bank Index remains way below its old high just below the 500 level, it has recently convincingly overcome a strong short term resistance level at 120:

Click to enlarge

Euro-Stoxx Bank index: moving above resistance.

Welcome to the Barbershop?

The question is whether this lack of concern is actually appropriate in view of the risks. Reuters continues:

Before the ECB takes over as supervisor late next year, it will conduct health checks of the roughly 130 banks under its watch. This is the nub of the problem facing finance ministers at the two-day talks.

With the eurozone barely out of recession, a failure to put aside money to deal with the problems revealed could rattle fragile investor confidence and compound borrowing difficulties for companies, potentially killing off the meek recovery.

In turn, that raises the question about who pays for the holes that are found in balance sheets in countries such as Spain and Italy. While Rome and Madrid would like easy access to the euro zone's permanent bailout fund, the European Stability Mechanism, Germany, Finland and other strong countries say each country should pay for its own clean-ups.

This time around, the task of cleaning up banks should not be quite as daunting as five years ago because shareholders, bondholders and wealthy depositors can expect to take some of the losses, as happened in the bailout of Cyprus in March. But if that is not enough, it will fall to governments to pick up the tab.

Although technical, talks about banking union have sparked an acrimonious debate touching on fundamental questions such as rewriting basic EU law that risk dividing the European Union.

(emphasis added)

Judging from the state of the debate as of the Cyprus bailout, the new rule is that not only bondholders and shareholders, but also large depositors of failing banks must expect haircuts. Depending on how big such haircuts eventually become, they could actually end up shrinking the euro area's money supply. Moreover, any bank that comes under suspicion of hiding large losses must expect a run on its deposits.

All of this is actually as it should be - and it is only possible because the interests of the paymasters are not congruent with the interests of those hoping for bailouts. We don't expect this principle to change, but on the other hand, the possibility that politicians in the euro area might get cold feet and opt for bailouts instead of haircuts cannot be ruled out. The trick will be in selling such a policy to the already overburdened tax cows.

Political Risks

Said tax cows have lately become rather restless, as inter alia shown by the municipal by-election that was recently won by Marine Le Pen's Front National in France. If you read Mish's assessment which we have linked to, he is quite correct when he states that the whole EU and euro project could easily be derailed by political developments. Populist parties continue to gain support amid euro-land's economic decline, to the point where they represent a real threat to the EU.

We would add that Ms. Le Pen's FN, although it has received a "face-lift" to rid it of the more obviously objectionable parts of its far-right image, still pursues an economic agenda that closely resembles the autarkic economic program of the German national socialists of yore. The FN is not just another version of UKIP, with its far more libertarian streak. Although we sympathize with Ms. Le Pen's anti-Brussels technocracy stance, her protectionist mercantilistic agenda is just as doomed to failure as Mr. Hollande's milder version thereof (note that the differences between socialist and national socialist economic programs are only of a cosmetic nature; not surprisingly, the FN's gains have largely come at the expense of the socialist party). In spite of the intellectual bankruptcy of France's political mainstream, it is a bit disconcerting that the FN actually leads in national polls at present. France's voters seem eager to "chasser les démons par Belzébuth", i.e., to replace one evil with an even worse evil.

This brings us back to the banks, which have incidentally become quite a popular target of Europe's populist political parties. They are quite correct in objecting to bailouts of course. The point we want to make is merely that any upcoming revelations of additional large losses hidden at European banks have a political dimension that could go well beyond the current 'banking union' related discussions.

Chart by: BigCharts