The European debt crisis is far from over. Markets reacted euphorically in the immediate aftermath of the most recent European summits (there have been so many we are going to have to call them something else). Upon reflection, however, they seem to understand that there is a large distance between agreement and implementation. Any plan that leaves final budget authority with national governments leaves intact the fault line between political and fiscal union that lies at the heart of Europe’s problems. It leaves in place half a union, and half a union is no union at all. Other than tightening the Maastricht budget rules, the summit is little different than the Stability and Growth Pact that it is intended to replace. We all know how well that pact has worked.
The summit also promoted a plan for the ECB to lend money at low rates to European banks that will in turn use that money to purchase more sovereign debt. Loading these banks with more debt to buy more bad debts makes absolutely no sense at all. It is another monetization scheme that is doomed to failure and could even hasten the collapse of the banks foolish enough to participate. This plan is truly no different than a bar owner lowering the price of drinks so drunks can increase their alcohol consumption.
As European leaders do virtually everything but address the structural flaw at the heart of the European Union and anti-growth fiscal policies that cry out for reform, the economic slowdown in Europe is gaining momentum. Contributing to – if not driving – the slowdown is a massive shrinkage of the balance sheets of European banks. Shrinking bank balance sheets are a highly deflationary phenomenon that suffocates economic growth. Combined with the austerity plans being adopted by governments throughout the region, European bank shrinkage is a major headwind to economic growth.
European banks obtain most of their funding (about 70%) from institutional sources such as American money market funds. Since the advent of the European debt crisis earlier this year – and especially since the summer – these funds have steadily reduced their exposure to Europe. Moreover, U.S. regulators have tightened up the rules on what these funds can hold, which renders it unlikely that they will be significant sources of capital for European banks in the future. Fitch Ratings tells us that these funds’ overall exposure to European banks dropped sharply by the end of October to 34.9% assets from as much as 50.2% at the end of June. Their exposure to French banks, for example, dropped from 15.5% of assets in May to 5.5% in assets at the end of October, contributing to rumors of troubles at some of France’s largest institutions. This drop has been compensated for by higher borrowings from the ECB, which have increased to €834 billion. Without the support of the ECB, one shudders to think what would happen.
This deleveraging is exacerbated by the difficulties European banks are experiencing in accessing dollar funding. According to Bridgewater Associates, Eurozone banks hold nearly $4 trillion in US dollar assets with 90% of these funded with institutional money. More than half of these assets are tied to non-European sources, which makes it politically easier for banks and their regulators to see them reduced in lieu of selling European-based assets. European banks have just started selling these assets, but several of them – BNP Paribas (OTC:BNOBF), Societe Generale (OTC:SCGLF), Credit Agricole (OTCPK:CRARY), Deutsche Bank (DB), and Banco Santander (OTCQB:BCDRF) – have announced active plans to sell dollar assets. Massive reduction of dollar assets by European banks cannot help but pressure asset prices and reduce capital availability. The recent move by the world’s central banks to ease the cost of dollar funding may cushion the blow of deleveraging, but the implications of what is happening are highly negative.
The other 30% of European bank assets that consist of retail deposits are also coming under pressure, a process that is likely just beginning. One of the purposes of the European Union was to facilitate capital mobility, and that is one goal that has been accomplished. As a result, there is little to stop a French citizen, for example, from moving his funds out of grossly overleveraged Societe Generale or BNP Paribas into a better capitalized Swiss or Norwegian bank. We are starting to see this happen already. In October, Greek and Irish deposits fell by €6.9 billion and €2.0 billion, respectively, and are down 15% and 10.7% year-over-year, respectively. Analyst Christopher Wood of CLSA also points out that the nominal value of total deposits in a number of European countries (Belgium, Germany, Ireland, Netherlands and Greece) today is still well below 2008/9 highs. As the media continues to spread the word that European banks are in trouble, we can expect more deposits to seek safety away from the most highly leveraged banks in the weakest countries. This will increase the pressure on these banks and contribute to a slow motion asset decline that could turn into an all-out bank run at any moment.
The European crisis is being played out in Europe’s banks and their desperate efforts to shrink their balance sheets without rendering themselves insolvent and taking the rest of the global economy with them. Bankers’ mistakes and misjudgments contributed mightily to the crisis, but capital mobility and the single currency played a big role in facilitating their ability to get into trouble. Even if the banks can be stabilized, they will not be able to prosper and promote growth under the current regime. And if the politicians can’t manage this change, the markets will manage if for them.
At a time of year that calls for reflection, European leaders need to begin reflecting on why they lack the courage to admit that the European Union as originally structured is not viable. The aspirations behind the formation of the EU are noble, but they are running into the reality of trying to force 27 different cultures, societies and economies into a single model. The longer the leading members cling to the hope of saving an economic union that lacks political unity, the worse the ultimate crisis will be.