Europe’s Bank Problem

By Global Macro Monitor

Another informative chart from the IMF showing the fundamental problem in Europe’s banking system – excessive leverage and dependence on wholesale funding. Add to that overexposure to highly indebted sovereigns with deteriorating credit fundamentals. It also illustrates why the German DAX and French CAC stock indices have been hammered over the summer and are two of the worst performing markets this year.

The arrows indicate the direction of the data points from 2007-2010. It also illustrates how the U.S. and U.K. got religion about strengthening their banking systems after the financial crisis.

How did the Euro banks get so levered up? The London Banker explains it best:

A primary fallacy of the Basel Accord is that OECD government debt is risk free and requires no bank reserves. Better yet, the banks can count the government debt they hold as Tier 1 capital, reserving against other debt assets. The Basel Accords assume all OECD government debt is a cash proxy, being liquid in all market conditions…

Roughly, the risk weights of the main asset classes under Basel I were:

– zero for Zone A (EEA and OECD) government debt of all maturities and Zone B (non-OECD) government debt of less than one year;

– 20 percent for Zone A inter-bank obligations and public sector entity debt (e.g. Fannie Mae, Freddie Mac, et al.);

– 50 percent for fully secured mortgage debt;

– 100 percent for all corporate debt…

With Basel II they could reduce capital even further by writing each other a daisy chain of credit default swaps for all categories of exposure…

OECD government debt is zero risk weighted and accounts for a disproportionate bulk of Tier 1 capital of major banks. A default by any EEA or OECD government will force banks and central banks to recognise that government debt has inherent risk like all other debt. This would force recognition of a positive risk weighting, and bring into question the assumption that government debt can be counted as a cash-proxy in Tier 1 reserves. The illiquidity of impaired or defaulted government debt would undermine its role as a Tier 1 reserve asset in bank capital models…

If any OECD state were to default there would be very serious implications:

– The Basel Accord zero risk weight of government debt would be proved fanciful;

– The assumption of government debt as a liquid asset suitable for bank Tier 1 reserves to meet unanticipated and sudden cash demands will become unsustainable;

– Banks would be forced to recapitalise at much higher levels, forcing even sharper deleveraging and contraction of lending;

– Governments would lose the captive, uncritical investor base they have relied on to finance excess public expenditure for the past 30 years;

– Central banks could be forced to suddenly monetise even more government debt if required to meet the cash demands of a run on their undercapitalised banks.

Merkel & Co. finally seem to get it. Exit Trichet, enter Super Mario. It’s going to get interesting.

  1. David Lazarus says

    The Basel rules have been written to suit the banks for years and not to protect the sovereigns, and those who have to pick up the pieces if a bank fails. The UK government are now wisely stepping bank from total guarantees of the banks. They will need to stand alone if they are to survive. The banks have murky accounting since the ending of mark to market and the fact that they have offshore operations outside the area of regulation.

  2. Scary Biscuits says

    By ‘get it’, you seem to mean keeping the show on the road. This is not getting it in terms of fixing the problem.

    All the things the OECD describes as ‘very serious’ are in fact very seriously good. It is lunacy (and very convenient) that banking regulations force banks to accept government debt as zero risk and to discriminate against private companies. Unwinding this mess will indeed be very painful and a lot of government clients will lose their shirts (including bankers, civil servants and welfare recipients). It is, however, a necessary step before any real recovery can happen.

    1. Edward Harrison says

      By ‘get it’ I mean understand that we risk a systemic collapse by dithering. There are a lot of ways to get to a credible solution. But all of them involve either writing down government debt and recapping banks or giving a full backstop to government debt.

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