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Just how bad are the issues in the European banking system? Really, really bad. Here is some cheerful (and honest) commentary on the state of the European banking system (via John Hussman):

As we entered 2008, I put together a spreadsheet to track financial institutions that were of particular concern based on their gross leverage (the ratio of total assets to the institution’s own capital), and the ratio of tangible equity to total assets. The most leveraged institutions at the time were Fannie Mae, Freddie Mac, Bear Stearns, Merrill Lynch, and Lehman Brothers. That spreadsheet turned out to be a fairly good predictor of the institutions that would either fail, go into receivership, or require bailouts as a result of insolvency. The corresponding calculations for several major European Banks are below. These calculations essentially mirror Weil’s list. Landesbank Berlin, Deutsche Bank and Credit Agricole are of greatest concern. While Danske Bank technically has a higher leverage ratio than Commerzbank, it has a larger buffer in the form of common equity – Commerzbank has only 1% of tangible common equity against its assets, the other 2% being more bond-like preferred equity.

When you consider the fact that most U.S. banks, just before the U.S. credit crisis in 2008, sported gross leverage ratios of about 12 (where Citigroup, Morgan Stanley, Goldman Sachs and JP Morgan remain today), the gross leverage ratios of European banks today are truly astounding.”


Weil ends his piece with a simple sentence: “Dexia’s (OTC:DXBBF) demise is only the start.” We couldn’t agree more.

Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig and Paul Pfleiderer have covered this issue more thoroughly than just about anyone else. Their recent work on Europe shows just how bad the leverage issue is. Leverage ratios are through the roof:

The problem in the modern banking system remains one of leverage where our banking institutions do everything they can to maximize their leverage in order to maximize profits. It’s an inherent conflict of interest between the public purpose of issuing state money and being a profit maximizing entity. Leverage is all well and good until the inevitable de-leveraging cycle hits and results in a balance sheet spiral in which asset price declines lead to fire sales of assets, illiquidity, general economic uncertainty as our banking system freezes up and bailouts. This leverage is not necessary! Admati, DeMarzo, Hellwig and Pfleiderer call it “an unnecessary evil”. They conclude the high leverage is not inherent to banking and entails a large social cost. They’re exactly right. But we allow the banks to leverage government money without regulating them properly. This is the equivalent of having politicians spend our common currency without ANY oversight. The lunacy behind such a policy is absurd. And it’s now resulted in risks to the global economy that quite frankly should never have existed in the first place. But we tore down the regulations and now we have a global banking system that is bloated and ripe for massive contraction.

Credit Suisse has concluded that the European banking system is largely bankrupt and could require a €400B capital infusion:

We present in this section an overview of the analysis which we published in our report ‘The lost decade’ – 15-Sep 2011. One of our conclusions was that the overall European banking sector is facing a €400bn capital shortfall which compares to a current market cap of €541bn.

In the words of hedge funder Steve Cohen: “Leverage, concentration and illiquidity are the three things that can kill you.” Love him or hate him, Cohen is a master risk manager. The global banking system could learn a thing or two from him.

The Europeans should ignore every bit of advice Tim Geithner has given them thus far. If they’re going to save their banks, they should go Swedish on them:

To gain credibility from the markets and be accepted by our citizens, such a backstop needs to be guided by four principles. The purpose is to safeguard the financial system, not shareholders. Bank share purchases should be based on conservative market prices reflecting the value of the failing bank in the absence of support measures, with “haircuts” if necessary. Prices should be determined after due-diligence from a third party. Second, when taxpayers risk their money, they should receive the potential upside of the investment. This is vital in mitigating moral hazard.

Third, public capital injections warrant public control of bank management, including strict control of dividend policy, bonuses and salaries. This is vital to deter dangerous risk-taking and to ensure public support for using taxpayers’ money. Fourth, the backstop should operate at arms-length from national governments without political involvement in commercial decisions.

Of course, saving the banks is just the start. If Europe really wants to fix their banking crisis they need to fix the currency imbalance which will inevitably recur if it is not resolved. That means creating autonomous monetary unions of some sort (full union or full break-up). If they’re willing to save the banks, they should at least have the decency to save the citizens from inevitable depression that will result if this currency crisis is allowed to persist. Saving the banks from their stupid decisions is not a cure to the disease that is ravaging Europe. Take it from an American, that lesson has been learned the hard way.

Source: 'Dexia's Demise Is Only The Start' In Europe