We recently mentioned that the balance sheets of the three biggest French banks amount to some 250% of French GDP. It should be noted in this context that the entire French banking system holds assets worth 400% of France's GDP (at least that is the stated book value of said assets, which is probably somewhat dubious).
In other words, 'bailing out' these banks if push comes to shove will be a very difficult task (we are not advocating such bailouts, we merely take it as a given that the big banks will always be bailed out if possible). Such large bank balance sheets can only be supported when confidence in the system is high. Essentially, all the governments of the regulatory democracies of the West are bankrupt, as it is impossible to pay their debt back (in theory it could be done by confiscating a large chunk of their citizen's wealth, assuming it can then be sold for the prices it is currently valued at and assuming that citizens will sit still and allow it to happen). In short, the system of 'eternal debt' only functions as long as confidence is high enough to enable a constant rolling over the existing debt stock. This same debt is however a major asset in the books of commercial banks.
For instance, French banks are exposed to Greek debt (both public and private) to the tune of € 40 billion. Should Greece not only default but reintroduce the drachma, then one can probably expect an enormous haircut on this exposure. Since a Greek withdrawal from the euro would likely spark a major crisis and contagion elsewhere, the exposure of banks to debt of other euro area nations would be similarly subject to impairment. It is not very difficult to see that this could wipe out a good chunk of their capital. It is also not too difficult to see that a major bank run would likely ensue.
The exposure of European banks to Greek debt in US dollar terms. Evidently, the French banks were the biggest 'yield hunters' in Greece – click for higher resolution.
In the September issue of the Elliott Wave Theorist (which we find always a very interesting read, even though we don't always agree with its conclusions), Bob Prechter made two remarks that are well worth quoting in this context:
“Global credit deterioration is objectively real; but disaster will strike only when it becomes subjectively realized”
and ibid.:
“In 2008 there was a credit crisis. The next five years will bring on the credit crisis.”
As it happens, the thin thread of faith by which the whole system hangs becomes more threadbare with every passing day. Readers may recall that we have occasionally mentioned that Germany's banks are actually the most highly leveraged in all of Europe in terms of the ratio of their assets to tangible book value. Consider though that neither the value of these assets nor this 'tangible book value' are actually fixed magnitudes. As the value of collateral and assets declines left and right, banks are faced with what we have termed the 'moving target problem'. Even if they raise a lot of capital as the US banks have wisely done when the getting was still good, they are soon back at square one if the value of the collateral backing their loans keeps falling. This phenomenon is especially pronounced in nations where enormous real estate bubbles have collapsed, such as the US, Ireland and Spain. In Europe the plunge in the value of sovereign debt has added a widely unexpected new twist to the situation, as banks were, and still are, not forced to keep any reserves against such assets. This means that any losses that will eventually be realized (and there will be such losses) will directly impinge on their capital positions without taking a detour through loan loss provisions.
So how far along are we on the road to a 'subjective realization' of the credit deterioration? In this context we only need to consider the never-ending barrage of bad news hitting euro-area banks in recent weeks. We have already discussed the fact that US money market funds are busy cutting back their vast exposure to euro area banks. However, one should keep in mind that said exposure remains a threat, as it is estimated to still exceed $1 trillion.
Then came news that the Bank of China has halted foreign exchange swaps trading with several European banks (reportedly with the big French banks that were recently downgraded by Moody's). Another unnamed Chinese bank concurrently halted interest rate swaps trading with euro-land banks.
This was followed by news that Germany's ten biggest banks banks are thought to require € 127 billion in additional capital (good luck with trying to raise that amount in the present situation). This was followed by a rumor – later officially denied (and therefore probably true) - that Siemens had withdrawn € 500 billion from French banks and 'parked the money with the ECB', where it is thought to 'shelter up to € 6 billion' according to the FT. Note that Siemens actually has a banking license, so it can indeed deposit funds with the ECB (back in the early 1980's when we first traded German stocks, Siemens was widely known as 'the bank with the loosely affiliated electrical goods department').
On Wednesday it became known that Lloyds of London has pulled its deposits from European banks.
The ECB has meanwhile allotted another $500 million in dollar liquidity to a European bank in a weekly tender (this is probably a rollover, but still a sign that dollars are hard to come by).
And in an additional clear sign that the crisis is taking a dramatic turn for the worse, the ECB has just suspended a number of eligibility requirements for bank collateral in repos, i.e., it has opened its doors wide for all sorts of toxic waste for which no market exists:
“The European Central Bank (ECB) has today published an updated consolidated version of “The implementation of monetary policy in the euro area: General documentation on Eurosystem monetary policy instruments and procedures”. The version published today mainly includes changes on 3 aspects:
First, the Eurosystem has abolished the eligibility requirement (Sections 6.2.1.5 and 6.2.1.6) that debt instruments issued by credit institutions, other than covered bank bonds, are only eligible if they are admitted to trading on a regulated market. At the same time, the Eurosystem risk control measures for marketable assets (Section 6.4.2) have been amended. Specifically, the Eurosystem has reduced the limit for the use of unsecured debt instruments issued by a credit institution or by any other entity with which the credit institution has close links. Such assets may only be used as collateral to the extent that the value assigned does not exceed 5% of the total value of collateral submitted (instead of 10%, as previously stipulated).
Second, the introduction of a common minimum size threshold applicable to all eligible credit claims throughout the euro area has been postponed to 2013 (Section 6.2.2.1).
Third, in order to stress the importance of counterparties’ compliance with existing national anti-money laundering/counter terrorist financing (AML/CTF) legislation, a provision has been introduced (Section 1.4) stating that all Eurosystem counterparties are deemed to be aware of, and must comply with, all obligations imposed on them by legislation regarding AML/CTF.”
The ECB might want to reconsider the third point, if the rumors that drug money kept US banks afloat during the Lehman crisis are actually true (this was claimed by the chief drugs and crime advisor to the UN; we see no immediately obvious reason to assume that he wasn't truthful).
So we can already state that a bank run is underway – in addition to the bank runs that have bedeviled peripheral nations like Greece, Ireland and Portugal for many months already. The latest examples are in fact happening in the euro-area's 'core'. Banks will become more and more reliant on funding from the ECB as a result (hence the change in collateral eligibility rules).
The IMF also keeps contributing to the souring mood, this time by releasing new estimates as to the losses euro area banks will likely face as a result of the sovereign debt crisis – the latest estimate is for $410 billion.
Meanwhile, the split at the ECB deepens, as Buba president Jens Weidmann meets with his allies on the bank's board in his quest to get the ECB to abandon intervention in euro-area's government bond markets. While the ECB is unlikely to follow this line, the evident split will serve to increase investor uncertainty further.
