Since the 2008 crisis, PIIGS’ financial problems are getting worse. I want to note that the banking sector is the one with the biggest risk of insolvency. During recent months I wrote about the bad situation of Italian banks. While mainstream media focus on everything but the facts, the situation doesn’t improve – a few days ago a strictly financial matter evolved into a political quarrel. Matteo Renzi – Italy’s PM – accused ECB head Mario Draghi of not doing enough for his country with regard to collapsing banking sector. This is how one man can be publicly blamed for the crisis felt by the whole nation.
The problem
Italian banks have a big deficit in their balance sheets. This deficit is 360 bn EUR and is due to delays in repayments or lack of thereof on credits given to clients. The problem is equal to 17% Italian GDP and with current public debt of 133% of GDP it is too much to handle for anyone. What is more, is the capital flight from the whole banking sector (deposits and shares) turns a grim situation into a dreadful one.
The government tries to save the day with direct help and a capitalisation fund which aims at helping institutions lacking liquidity. The idea may be noble but the minuscule amount of money gathered will not be enough. Also, means are acquired from other banks putting more strain on (still) healthy institutions.
Why would Mario Draghi be the one to blame here? He managed Italian Central Bank between 2006 and 2011 and this is when Italian banks were hit the hardest. Of course, he cannot be the scapegoat for every single Italian mess but just because he bears high enough office – for political reasons - he fits the profile.
It matters little who is at the top of crucial institutions because the system itself is set to accumulate more debt and lead public finances to implode. When Italy was joining Eurozone the core issues were already there and after years they evolved into banking crisis today. With the lowest interest rates in history, thanks to the single currency and common monetary policy a credit boom started. The society is known for being financially prudent and disciplined was given cheap (‘free’) money. On top of that, European Keynesians encouraged everyone to spend money to help the economy grow. In normal circumstances, this would lead to quick devaluation of the currency, bankruptcies and return to the ordinary economic environment. In Italy's example (we evaluate this country but you definitely can find parallels with others) every correction mechanism was removed thanks to the fiscal union between Southern Europe being on a spending spree and rich countries of Northern Europe. When the South lived off credit, the North made money on increased exports.
The only possible consequence – banking crisis – was an inevitable scenario which now threatens whole Europe. Italian banks are one of many insolvent institutions in the Eurozone and each can be the first domino causing the monetary union to collapse.
To save the day, Mario Draghi unofficially gave 250 bn EUR to the failing sector. This was not enough to counter outflow of money from deposits and unpaid junk debt. The first thing that goes through central bankers mind is to print more money but Germany is vetoing this decision – judging after Greece they would like to buy valuable assets for a fraction of their worth.
The Endgame(s)
In the short-term, Draghi can ease the situation with his junk asset purchasing program from insolvent institutions. Again, coupled with swap contracts enabling additional liquidity, it may not be enough. We saw this scenario in Greece where although banks restricted withdrawals of funds, capital still was not staying in the sector but back then Angela Merkel accepted the ECB printing required sum to stabilise the situation.
Today the Chancellor of Germany is against the use of taxpayers’ money to save Italy. Lorenzo Bini Smaghi – head of Societe Generale (PA:SOGN) and former chairman of the ECB – has a different opinion. He believes the EU should refrain from bail-in directive (controlled removal of insolvent banks) and print enough EUR to save collapsing banks.
Bail-in is not playing into hands of authorities around Europe because it draws the attention of the spotlight. The cost of bankruptcy is dropped on the backs of clients and this makes them question giving hard-earned savings to any ‘institution of public trust’. If this is not bad enough, electronic currency takeover by the bankrupt would automatically make cash valuable. This is against the underlying narrative of the war on cash. Another bad possibility of bail-in is a big exposure of banks to mutual losses. The domino effect here will be bigger than in 2008.
The result of a bail-out is much more covert, especially to the public which lost understanding of today’s world of finance. Taxpayer also in this solution is saving the day but the burden is shared among bigger population. Additionally, this burden is not direct but rather hidden in the rising debt servicing cost that the government is paying to creditors who buy insolvent institutions.
Ultimately we have two options. First one is to let banks fail and save healthier part of the sector to be able to start with a new (much less leveraged) system. The other option is to print and pump countless billions of EUR and stabilise situation until the next crisis hits in just a few months.
Summary
Will the ECB act similarly like in Greece a year ago? We cannot be sure but I believe it is going to happen this. As long as Draghi has the opportunity to print money he will do so. Nothing else is left in his notebook – interest rates are already at zero and negative area will push the capital outside of banking system even quicker. No one in their right mind is going to keep money in the bank and pay for that 'privilege'. Much safer is to simply put money in the deposit box just like they tried in Switzerland.
Solvency of banks is of secondary importance. The society’s trust in the system is at the stake. An example of British funds freezing assets of their clients showed investors that the time for risky speculations is finished and this is the moment to move at least share of money to safe havens. Those moments when public sobers up are the biggest threat to financial institutions. Not temporary losses of liquidity easily solved by another round of printing by the ECB.