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The banking system in Europe, particularly in Spain, is getting a lot of attention these days. The specific case that has been in the news is that of Bankia, the fourth largest bank in Spain.

Bankia is a special situation in that it was a consolidation of seven Spanish savings banks in December 2010. It is obvious now that those involved in the consolidation basically put the banks together without recognizing the serious condition of the loan portfolios of the combining savings banks.

The fact that the “hole” in Bankia’s balance sheet is so bad just highlights the incompetency of the Spanish banking authorities or their naivety given the serious state of the housing market crisis that Spain was undergoing at the time.

Here again, one wonders what role the European interpretation of the financial crisis played on this restructuring of the seven savings banks into one. If one assumes that the asset problems of the banks were connected with the liquidity of the loans, then, I guess, one does not feel that the value of the assets need to be written down. If one were to assume that the asset problems were ones of insolvency, then the authorities should have responded in a different way.

Europe, unfortunately … and incompetently … assumed that the problems faced by the banks were liquidity problems and not insolvency problems … and they just “kicked the can further down the road.”

“Can kicking” time seems to be over.

Now, however, the fear factor seems to be spreading beyond Spain to the rest of the European continent. “A fierce debate is now taking place as to the best way to avert a run that, if it started, might be difficult to contain and could lead to massive capital flight from the eurozone’s peripheral countries … ”

Proposals for a banking union that includes integrated financial supervision and deposit insurance have been flying around Europe last week.

These proposals have been accompanied by increased calls for a “full economic and monetary union.” But, again, this comes at a time when Greece may elect a government that rejects the agreed upon bailout provisions and at a time when Spain may also require a huge financial bailout to save not only its banking system but also its sovereign debt. The rest of Europe may not readily accept either of these outcomes.

The difficulties faced by officials in Europe (I will not use the term “leaders” because I see none) are highlighted when put into contrast with the banking situation in the United States. Although in the United States, Ben Bernanke and others at the Federal Reserve talked about the “liquidity” problems of the financial system, they were faced right away with solvency issues.

The most prominent of these was, of course, the case of Lehman Brothers Holdings Inc., which filed for bankruptcy on September 15, 2008. However, the Federal Reserve System and the Federal Deposit Insurance Corporation were faced with many, many more bank failures and bank consolidations soon after. All told, since September 30, 2008, the number of institutions in the commercial banking system of the United States has dropped by 884 banks! This is not an insignificant number.

In my opinion, the Federal Reserve ran its Quantitative Easing 2, at least in part, to help keep troubled commercial banks open and allow the FDIC to work with the banks in the worst shape to close or to find someone to acquire them in the smoothest and least disruptive manner possible. In this the American regulators have been tremendously successful.

Commercial banks have not really been giving out loans over this time period and hence help to underwrite the economic recovery. But, the consolidation of the banking system has proceeded without much fanfare and this is not all bad! At a bare minimum, this approach has provided some downside protection in the tepid economic recovery now taking place, protecting against any major disruptions from a cumulative closing of many banks within a short period of time.

The European situation seems to be going the other way. Officials not only treated the banking situation as one big liquidity problem it added to the problem by forcing the European banks to take on more and more of the sovereign debt of the teetering peripheral countries of Europe. Since the debt of the troubled European nations were assumed by European officials to be “riskless” the “troubled” banks could acquire the debt of the “troubled” European nations without suffering any decline in their existing credit rating.

Thus, suspicious credit was added on top of suspicious credit at these banks.

And, the regulators went about their merry way without raising any kind of question or doubt about the solvency of these banks! How blind can one be?

Then stress tests were administered … twice … by these same regulators in order to reassure depositors and investors of the soundness of the banks. The stress tests were a “bad joke.”

As a result, “Since national regulators have lost the confidence of markets, they are having to bring in outsiders to assess how much capital their banks need.” But, this could be a disaster if they are realistic and truly trustworthy.

Now, the authorities have to scramble. The European Union not only does not have the fiscal authority to oversee the fiscal affairs of the member countries and the EU as a whole, it does not have a unified banking authority to oversee and regulate the banking activities that go on within the EU.

It looks as if the anxiety in Europe is rising. Mario Draghi, in the words of the New York Times, has issued a challenge: “A Terse Warning for Euro States: Do Something Now” The Times article goes on to say “The note of frustration and urgency in Mr. Draghi’s voice was a sharp contrast to six months ago … ”

It is time that someone listened!

Source: The European Banking System