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For more than a year Europe has been muddling through finding a solution for its twin crises of sovereign debt and banking. With economic growth weak outside Germany, trouble sequentially spread to Greek, Irish, Portuguese and Spanish government debt, with spreads widening vs German bunds. In each of these countries, the banking sector has faced difficulties, inter-related to government debt spillover, increased bad debt, funding squeezes and weak capital position.

Key pressures are re-building. The second European bank stress tests are under way. While the assumptions are slightly more rigorous, focus is now on the core Tier 1 ratio, which will identify more banks with capital shortfalls. New candidates will emerge from the Spanish, Italian and German banking sectors. Nearly US$1 trillion bank debt matures in 2011. Weak economic growth and worsening loan loss trends continue to be self-reinforcing. Spanish banks have been downgraded by Moody’s following revisions on its sovereign debt and a political crisis triggered by its debt restructuring has emerged in Portugal. Continuing geopolitical risk in the Middle East and the Japanese earthquake serve only to add to the risk.

Lacking a political union, the EU’s political elite has been unsuccessful in reaching a timely consensus. The European Financial Stability Facility (EFSF) announced last summer fell short (see here and here). The European Central Bank, forced to intervene in the government bond market, continues to be integral to wholesale funding for parts of the banking sector.

The European Stability Mechanism (ESM), coming into force Jan 1, 2013, addresses some EFSF shortfalls including: countries are now required to cumulatively put up €80 billion in cash through 2016, raising its effective borrowing capacity up to €500 billion; a further €620 billion in “committed callable capital”, i.e. pledges, is available; the facility has the right to purchase bonds directly from a government; and the lending spread is lowered by 100 basis points. The ESM is expected to enjoy “preferred” creditor-status and existing bondholders can (will?) be co-opted in restructuring of sovereign debt. While these last two points currently lack clarity, accepted rules are being thwarted with serious implications for the bond market.

Still, the adequacy of the ESM facility remains entirely dependent on whether the funding needs of Ireland and Greece worsen, how much Portugal and, more importantly, Spain will require and whether Italy will succumb to these spillover effects. While Germany’s economy continues strongly, it bears the largest burden of ESM funding and has a domestic bank sector that awaits restructuring and re-capitalization.

The urgency to address the EU’s fiscal situation and bank sector cannot be overstated. Whether the recent build-up of events force a solution remains yet to be seen. Any investments in European banks should at least await more visibility on bank stress test results due in June. However, if no resolution on these other issues is forthcoming, the dismal outlook for European banks continues.

Source: End Not Yet in Sight for European Bank Problems