Crisis in Europe: an article I wrote in today’s Guardian

By Edward Harrison On Oct 2, 2008

Below is an article I wrote that appears in this morning’s Guardian Newspaper in the UK. The crux of the article is that European politicians need to realise that their banks are not immune from the crisis that has hit the United States and that European banks are relatively under-capitalised.

The Europeans need to come up with a comprehensive solution to this problem or we may see more turmoil in Europe going forward. At the end of this post are some links to previous posts I wrote these past few months warning that the credit crisis is coming to Europe.

Europe’s turn to scramble

It was the week the credit crisis swept Europe. The fireworks began on Monday as Glitnir bank in Iceland was nationalised; Hypo Real Estate in Germany was rescued by a consortium of other German banks; and Fortis, the largest private employer in Belgium, was propped up by governments in the Benelux countries. Rounding out the wave of European banking fragility were the nationalisation of the UK’s own Bradford & Bingley, the Irish government’s move to guarantee deposits and debt at six large banks in Ireland, and the bail-out of Dexia by Belgium, France and Luxembourg.

Politicians need to use the summit called by the French president, Nicolas Sarkozy, to develop a workable and comprehensive plan. The priority must be preventing healthy financial institutions from becoming insolvent simply because they temporarily lack liquidity. The excessive risk taken on by banks globally and the opaque nature of the derivatives market has caused banks to fear lending to one another. When BNP Paribas froze withdrawals from three investment funds because of U.S. sub-prime exposure in August 2007, everyone realised large losses could be hidden anywhere. Clearly, some banks are hiding the ball, and since no one knows who owns what, interbank lending has virtually ceased. The interbank market has become a grand game of cards, with everyone afraid of getting stuck with the old maid.

Things could still get much worse, and soon. To halt the decline, European governments should follow Ireland’s lead and make an explicit guarantee of deposits to end potential distrust among depositors. They should bite the bullet and temporarily guarantee certain bank debt obligations to reassure banking counterparties. Guaranteeing interbank loans taken at Libor (the London interbank offered rate) should be sufficient to bring down interbank lending rates.

As guarantees increase moral hazard, the governments must require national regulators, such as the FSA, to quickly determine which banks are insolvent. The government can then decide on whether to liquidate these insolvent banks or sell their assets to other financial institutions. The private sector should be used to realise the remaining solvent banks. Many investors are ready to contribute capital under the right circumstances. However, if necessary, the government should contribute through preferred shares or warrants.

Regulators might look to separate "good" assets from "bad" assets in the solvent banks to further bolster interbank confidence. Instead of buying assets up at inflated prices, as treasury secretary Hank Paulson has suggested the U.S. government do, they should stick bad assets into a separate "bad bank" controlled by the regulators at market prices.

Ireland presents a model of action. The measures taken there and the others outlined above are needed immediately throughout Europe to restore confidence. Regulation can wait until this acute phase of crisis has ended.

When the acute phase is through, we can all begin to assess how to prevent crisis from recurring. Will Hutton said in these pages yesterday that one way Britain can avoid crisis in the future is to join the euro. I strongly disagree. As we shall see, Ireland and Spain, with their devastating property crashes but tied to the euro, will not fare well within the straitjacket of the single currency. Instead of joining the euro, regulation and capital requirements for banks that anticipate economic downturn will be of utmost importance.

But those are steps for later. Let us hope our political leaders understand the gravity of the crisis at hand and act swiftly to avoid economic depression.

Edward Harrison is a banking and finance specialist at Global Macro Advisors and author of the blog creditwritedowns.com