The Real Eurozone Crisis Is Not Greece, But Keeping The Banks Healthy

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Includes: EU, FXE, JPM, XLF
by: Steven Hansen

Over the last several weeks, JPMorgan Chase & Co (NYSE:JPM) has remained in the headlines after suffering trading losses tied to the bank's now infamous "London Whale" with losses at $7 billion more or less (yes, maybe more). With tangible assets at $125 billion, and annual pre-tax profit around $90 billion ... $7 billion may be pocket change in this case.

However, missteps by large financial businesses affect the economy as these institutions largely use OPM (other people's money). OPM is massively larger than the worth of the financial institution. When financial institutions screw up using OPM (or even their own coins), the ripples can spread across the economy as seen in the Bear Stearns and Lehman Brothers meltdowns in 2008.

A strong financial system is paramount for economic expansion, so the government steps in via central banks to provide bridging financing during high outflow periods, as well as insuring deposits / trading accounts. Financial institutions (without explicit government backstop) could never cover all the money owed to clients if demanded at once as the client money held is "invested" with high leverage and is therefore simply not available.

In return for this government "support", the banks are subject to more overview / audit and regulation than a normal business. Yet, even with regulation and audit, the financial industry walked to the edge of destruction in 2008 - and needed significant intervention by the government to buttress the financial system.

The current regulation and audit system today is not effective. Econintersect author William K. Black argued this past week that embedding auditors at financial institutions is dysfunctional.

We only embed examiners for systemically dangerous institutions (SDIs) - banks so large that they pose a systemic risk to global economy. Embedded examiners do not work. They get too close to the bank officers and employees. In the regulatory ranks we called this "marrying the natives." Nothing works with SDIs - they are too big to manage, too big to fail, and too big to regulate.

Auditing only finds the obvious, and the determined institution can easily disguise the gray and black functions until well after the damage is done (whether auditors are embedded or not). The JPMorgan Chase fiasco this past week shows current laws, regulations, and oversight are incapable of preventing another crisis.

This "London Whale" occurred after Basil III and Dodd-Frank Wall Street Reform and the Consumer Protection Act. It will take more than band-aids; a new approach to limiting financial institution activities and risk is needed. Systems need to be self policing with criminal (not civil) penalties as institutions are backstopped with public sector monies.

The markets reacted to positive news on Greece at the beginning of this past week, but then began to react to deteriorating news on the Spanish financial institutions (which provide the lubricant to make the economy function). What contagion is possible?

The European economies will implode if Eurozone banks begin to fail. Here we stand almost three years after the "end" of the last financial crisis - and the viability of the Euro banks still remains an open question in a Euro system which lacks a "real" Eurozone central bank. The ECB is hampered by not having a fiscal partner spanning the Eurozone. Having monetary policy without a fiscal companion puts severe shackles on the operation of a central bank.

Many pundits argue that the Eurocrisis will slowly be resolved just in time - as it takes time to line up (convince) each country state of each painful step. My headline is that even though the pundits may be correct, the Euro economies will contract in the meantime.

Economies with sick banking systems contract.

Click here to view my normal weekly summary of the economic indicators and analysis this past week. I believe that the headline BLS jobs report was overly negative (many will remember my usual complaint that many of the past jobs reports were too rosy).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.