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An agreement in principle on some version of a fiscal union among the nations of the eurozone now seems to be in prospect for the meeting of European heads of state December 8-9. If it comes together, it will change the calculus regarding European banks.

Background

European banks are undercapitalized by any measure except, perhaps, the lenient assessments of their national regulators. The markets have been telling us that since August 2007, when one of the early warnings of catastrophe was presented by an in increase in the TED spread (the spread between U.S. Treasury securities and LIBOR). The increase in the TED spread indicated that banks did not trust each other’s balance sheets and therefore did not want to lend to each other. Some European and American banks have been recapitalized since then and have access to interbank loan markets. But a larger number of banks have not been recapitalized to a point where they have adequate capital to support the in-fact riskiness of their balance sheets. Governments and managements have (perhaps understandably) sought recapitalization on the cheap rather than a strong banking system.

One might have thought that in the four years since August 2007 the European banks might have tried to wean themselves off reliance on short-term wholesale funding since, if the dangers of such reliance were not apparent in August 2007, they had to be apparent after the failures of Bear Stearns and Lehman Brothers and near-failures of several other banks had they not been bailed out. But apparently easy strategies die hard when so many banks with similar strategies got bailed out rather than failing.

Because European banks did not put their balance sheets in order, the European financial system came to the sovereign debt crisis that began to be public in 2010 with inadequate reserves and a schedule of liabilities that required new funding practically every day.

Long-term illiquid assets that are funded short-term have always been a recipe for banking disaster. But the Basel capital standards and European governments have encouraged European banks to embrace such strategies nevertheless. Thus, European banks are holding large amounts of European sovereign debt funded short-term.

Central Bank Loans to European Banks

This dangerous strategy has two pitfalls. First, if the financial world doubts that a bank has sufficient real capital (regardless of what its balance sheet or the regulatory authorities say), it will stop providing short-term funding. This will be perceived as a liquidity crisis, although in fact it is a capital adequacy crisis. In Europe over the last several months, this problem has been treated primarily as a liquidity crisis, and the ECB has been lending at less than penalty rates based on collateral that may or may not be adequate. Such central bank lending helps to keep the banks afloat, but it does nothing to deal with the underlying capital problem.

Similarly, the concerted action announced November 30 by six central banks to make dollars available to the ECB for on-lending to banks at a low rate addresses liquidity issues but not capital issues (except that low-cost funds should assist earnings that, over the medium term, do increase capital).

Underpricing Credit

European banks have been told that they must raise additional capital urgently, but most of them are saying that they prefer to sell assets to raise capital percentages rather than raising additional equity capital. This attitude almost certainly means that most asset-heavy businesses in which European banks engage are not very profitable, since a business should rather hold onto profitable business, if possible.

That brings us to one of the salient features of European banking: It systematically underprices credit. Some banks were founded specifically to underprice credit. These include the German Landesbanks that were founded to provide credit to small and medium-sized businesses, and Dexia, that was founded to provide low-cost credit to municipalities. This underpricing of credit has been fostered by governments and by the Basel capital standards.

Underpricing of credit, by definition, reduces earnings (and thereby tends to induce managements to under-reserve for bad debts). But underpricing of credit also has an unintended side effect: It stunts the development of capital markets. Mostly for this reason, European banks provide about 80% of funding to European businesses, as opposed to less than 40% provided by banks in the U.S. Thus, banks are far more important to European economies than they are to the U.S. economy. And that is part of why European governments will bail banks out rather than allow them to fail.

Threat of Sovereign Defaults—Negative Feedback Loops

That brings us to the heart of the matter: If major European nations default on their sovereign debt, many European banks will fail because they will deplete their capital and will be unable to raise more in the capital markets. That would force their governments to bail them out, which in turn would reduce their governments’ credit standing and increase their governments’ costs of borrowing, leading to a negative feedback loop that could end in the disorderly demise of the euro and a European Depression, during or after which anything could happen. That is not fanciful doom and gloom.

The leaders of Europe know that is not fanciful doom and gloom, and that is why they now are likely to act to move toward a fiscal union, with the support of the ECB to provide liquidity to banks and governments that require it while the difficult process of constitutional change goes forward. (I recognize that there are legal and political issues regarding the ECB’s ability to do this, but that is a separate subject. See my December 1 post “Mario Draghi’s Way Forward for Europe” for a partial discussion.) A fiscal union has many problems, but there is no perfect solution, and a fiscal union may the solution that is possible politically.

Reducing the Threat of Sovereign Defaults—Positive Feedback Loops

If the leaders of Europe successfully move toward a fiscal union or some other type of meaningful constitutional reform, the main threat to bank solvency—the default of major European sovereigns—will decline in likelihood. That, in turn, should permit European banks—after the passage of some time—to raise capital at more reasonable prices, and a positive feedback loop would result instead of a negative one. I am aware that I am building a sort of castle in the air by bootstrapping the survival of the euro as the major currency for Europe (not yet accomplished) into reform of the Italian economy, the survival of the major banks of Europe, and the survival of the relative strength of the credit of France. But note that the apocalyptic visions put this same house of cards in reverse.

The question of the solvency of European banks cannot be separated from the twin questions of the survival of the euro and maintenance of Italy and Spain as capable of servicing their debt. The Italian question may turn out to be the hardest, but with so much riding on it, perhaps Mario Monte, with the help of other European leaders, can pull it off. If Italy and Spain are enabled to service their debt, the threat to European banks’ solvency becomes significantly reduced, and the banking side of the problem becomes the most manageable.

Unfortunately, I am not optimistic that this process—even if successful—will result in European banks changing their basic business plans. I am afraid they will continue to underprice credit and will continue to rely on short-term funding. That is the moral hazard of saving them. But the moral hazard is, in this case, preferable to the consequences of not saving them or saving them only after they quite plainly have no capital and Europe has been launched on a probable Depression.

Source: What A Fiscal Union Agreement Would Mean For Europe's Banks