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Europe's Confidence Crisis

|Includes: DRR, EU, EUFX, EUO, CurrencyShares Euro Trust ETF (FXE), ULE, URR

According to figures released by the Spanish central bank, the net borrowing of Spanish banks from the European Central Bank rose for the 10th month in a row to 375.5 billion euros last month. This amount is a record high and underscores the increasing difficulty Spanish banks are faced with in their attempts to raise capital.

So why are Spanish banks (and the vast majority of European banks) forced to increasingly rely on loans from the European Central Bank? Because as the European sovereign debt crisis deepens, more and more investors and banks, out of fear of a Eurozone collapse, are limiting their exposure to Europe. This in turn has resulted in significant decreases in flows of capital to Europe. Depositors have withdrawn funds from troubled European banks especially as events have continued to spiral downward; take, for example, the bank jog Greek banks experienced before the decisive showdown between SYRIZA and New Democracy in the Greek election a few months back. Moreover, banks across the world are increasingly refusing to engage in interbank lending operations with their European counterparts. This in turn has resulted in significant decreases in the availability of credit in the European financial markets.

In fact, even European banks are hesitant to lend amongst themselves; in June, inter-European bank lending transactions declined to levels not seen since 2007. Moreover, according to AFP, European Central Bank data suggests that Spanish and European banks have been "parking it [funds loaned by the ECB] in the ultra-safe institution's deposit facility" instead of actively lending, further aggravating the credit problem.

This overall hesitancy and caution in the European financial markets is increasingly taking its toll on banks such as those in Spain. As Der Spiegel's Martin Hesse has noted, this phenomenon has resulted in a self-fulfilling prophecy: the very incident investors and banks are trying to limit their exposure to (the potential failure of the Eurozone) has become more likely to happen due to very actions taken in bracing for this possibility. The European Central Bank, originally a lender of last resort, has been forced to step in to fill the footsteps of the investments and loans fleeing from Europe. Moreover, the reluctance of banking institutions to lend to each other mitigates the effectiveness of the lending operations of the European Central Bank as European banking institutions express reluctance in transferring this credit to businesses and households.

This destructive self-fulfilling prophecy can be stopped by an infusion of confidence in European and international banking institutions, a development which will only occur with decisive action. Eurozone leaders can no longer afford to keep kicking the can down the road, a strategy which is dangling the Eurozone off the edge of a economic cliff.

There are various routes that could be taken by Eurozone leaders as decisive action. The European Central Bank could announce another "big bazooka" and offer trillions of euros of funding to banks at ultra-low rates; however, this time the ECB should include within its loans clear stipulations about loaning at least a certain portion of the funds to business and households to boost the economy. Moreover, the European Central Bank needs initiate the purchasing of sovereign debt of Spain and Italy, a power which is granted to the ECB in its constitution but has been blocked by political bickering. This would be seen as a vote of confidence for the economies of the aforementioned countries and will help cool down their stratospheric borrowing rates.

The reluctance by many investors and banking institutions to deposit funds in and lend funds to European financial institutions is understandable; after all, with no end in sight, the Eurozone continues to flounder through the European sovereign debt crisis. This in turn has created a confidence crisis in which the ability of the Eurozone to remain intact, much less prosper, is becoming increasingly questioned. Eurozone leaders need to change this mindset and show the world that the current state of the European economy presents huge opportunities, not risks, for investors. They need to engrain in the business world the notion that the Eurozone will stay intact and will be backed by the full power of such institutions as the European Central Bank. Only then will confidence start to be restored.

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