Long Look At Europe's Bank System

Lesson number one is that whenever a politician publicly states that “Our banks are well-capitalized and safe,” then you know they're not. If we hadn’t already learned this lesson from the financial crisis, there is now no excuse, given the political and subsequent market responses to the banking problems in Spain. On May 28th, Spain’s Prime Minister Rajoy declared that Spanish banks would not need a bailout. His statement totally lacked credibility given the year-long reports of severe real estate related credit-quality problems and accelerating losses by the IMF and other credible regulatory bodies. It is hard to believe that the conditions of Spain’s banks declined so unexpectedly and precipitously between May 28 and June 10th as to require a capital injection of 100 billion-or-more euros.

Solvency: Then And Now
It is time to take another look at Europe and its banking problems and face a few facts. What we are seeing in Europe parallels exactly what we saw in the U.S. in 2007, when the September financial crisis was perceived by regulators as a classic, short-term liquidity problem. The Fed responded in the classic way, making credit freely available to the primary dealers who were having difficulties financing commercial-paper rollovers in the overnight markets. What history proved is that the problems had to do with issues of solvency, not a temporary lack of liquidity. Markets fundamentally questioned the quality of bank and investment-bank assets and the quality of the collateral they were posting to obtain short-term funding. And this is exactly what's happening now in Spain, Ireland, Italy and Portugal, to name just a few countries.

The problems of funding are not liquidity problems. They clearly reflect solvency concerns, which is reflected in bank and sovereign credit spreads. (Cumberland has been posting sovereign-debt spreads on its website for some time now.)  To make matters worse, we still don’t know the true magnitude of the problems or exactly how the bailout will be structured, hence markets are reacting to the present bailout/recapitalization with healthy skepticism. In fact, rumors that Spain's injected funds will be senior to existing funding sources will only accelerate the exodus of wholesale funding and raise the costs of funding to Spanish banks due to uncertainty about the ability to get repaid in the event of default.

The Silent Run
Secondly, given the problems in Spain, why haven’t depositors lined up to get their money, the way they did in the Northern Rock case in the UK?  Clearly, runs are taking place. They are silent runs by wholesale funding sources that manifest themselves in the pseudo-liquidity problems that Spanish banks have experienced. These same runs also hit Northern Rock long before people lined up to get their funds and were widely broadcast on television.  When it became apparent that Northern Rock was insolvent, the Bank of England and the Chancellor of the Exchequer jointly stated that they would provide liquidity, which only triggered greater runs by confirming that the institution was in trouble, leading to the run by retail depositors. 

Reasons for the retail run were several-fold. There was a fundamental flaw in the design of the public deposit insurance contract, which only covered 100% of the first £2000 and then only provided 90% coverage up to £35,000. That co-insurance, combined with a lack of a failure regime and ability of the regulators to close the bank, created uncertainty about the ability of small depositors to get their money. The run was stopped -- not by the Bank of England and its liquidity-provision facilities -- but by the government, which provided 100% deposit insurance for all banks and the subsequent nationalization of Northern Rock.

Spain Compared To Northern Rock
The situation in Spain differs from that in the UK in two important respects.  Unlike the UK, Spain has 100% deposit insurance coverage. Hence, retail customers believe they will get their funds, euro for euro. More importantly, in Spain, as in most European countries, the banking system is not strictly a private-sector system. Partly as a result of history whose policies aimed to create “national champions", Europe has developed an extreme aversion to bank failures and closures.  As a consequence, the European banking system, unlike that of the U.S., is now a mixed private-public system with significant government investments in, and partial ownership of, banks, which evolved through sponsored nationalizations, consolidations and forced mergers of troubled institutions. This public ownership expanded further during the financial crisis, as European governments attempted to limit the perceived damage that bank failures might cause.

'Super GSEs'
As opposed to viewing Spanish, and more generally European, banks as private-sector institutions, it is more appropriate to consider them as super-GSEs, analogous to Freddie and Fannie. Like Freddie and Fannie,  European super-GSEs are perceived to be government-guaranteed entities that will not be permitted to fail or to impose losses on providers of funds. In fact, now that Freddie and Fannie are in receivership and are essentially government-owned, the parallels are even stronger.

Public ownership of banks puts the European sovereigns’ reputations on the line. They now must back their institutions with taxpayer wealth -- whether by taxing or borrowing as Spain has done, or be perceived as insolvent. Under such a regime, if the government-sponsored banks were to fail, it would be because governments were unable or unwilling to tax citizens’ wealth to cover losses. Unfortunately, simply committing wealth isn't enough; and that's where some of the European pressure is coming from to ensure reforms, which Spain may or may not actually live up to, since there is no enforcement mechanism to ensure compliance. Note, too, that if European and IMF loans or capital injections are senior to other creditors, it will change the terms of current-bank debts by government fiat.

Fiscally Challenged Debt Buys
There is an additional complication in that the GSE-like European banks are also purchasing the debt of their sovereigns, which has created a vicious circle of debt financing. Fiscally challenged governments are issuing debt that is purchased by government-owned and-sponsored banks, which in turn pledge that sovereign debt for funding at their respective national central banks. Thus, troubled sovereigns are using the state-sponsored banking systems and their national central banks as a way to partially finance their deficits.

Public Or Private?
Finally, the sad thing about all this is that the Basel Committee on Banking Supervision continues to fiddle with increasingly complex rules and prudential regulations. It has not recognized the true nature of the banking structure in Europe. It is blindly constructing capital-adequacy rules and supervisory policies for a private-sector financial system, when what they have, of course, is a government-sponsored financial sector that does not respond to the same incentives that a private sector does. There are two problems here. Governments are notoriously bad at running businesses and delegating that business to bank managers who are paid and incentivized as if they were private-sector bankers will result in their behaving exactly as the managements of Freddie and Fannie did when it comes to exploiting government guarantees and taking on excessive risk.  What the Basel Committee should be focusing on is limiting moral-hazard behavior on the part of bank management to protect taxpayers who are ultimately at risk, and not constructing a system to limit private-sector financial risk taking.

Uncertainty Drives Markets
The bottom line is that we are seeing a market response to uncertainty that governments will live up to their explicit and implicit commitments to guarantee the liabilities of their GSE banks. This is a referendum on the sovereigns, their solvency and comittment to face their problems, not their banking systems. In the US, our experience with state-sponsored deposit insurance funds should serve as a stark warning sign on the road the Eurozone is currently traveling. Every one of those deposit-guarantee systems went under when the sponsoring states were either unable or unwilling to live up to their commitments.

Simply injecting funds, which is the current European response, without dealing with both the banking-structure issues and fiscal concerns, will not solve the problem.

BY Bob Eisenbeis