Europe’s Banking Crisis Is No Longer a Liquidity Crisis, nor Is It a European Version of ‘Subprime’ – It’s a Sovereign Coordination Crisis
I often hear that Europe is trying to avoid its ‘Lehman event’, or that the PIIGS euro area bonds are the European equivalent of subprime bonds. Rather, the European banking crisis is centered on a failure of public coordination that’s made explicit and implicit holdings of sovereign assets a risk to even the healthiest of banks.
First, why euro area bond exposure is not the European ‘subprime’ exposure. Cross border bank exposure to the Periphery economies is widely known in Europe, as clearly listed through the BIS banking statistics (see Table 9b). Therefore, the first-order losses from any country taking, say a 50% writedown on Greek debt, is known and preparations can be made. In contrast, policy makers during the US subprime crisis had no idea what they were dealing with, even the securities themselves were little known by Fed officials (I saw Brian Sack speak in 2009 – he stated this point exactly). (Note: If you haven’t already, I highly recommend the Financial Crisis Inquiry Report.) Furthermore, European banks raised capital (at least the big ones have) and acquired USD cash buffers to finance their dollar-denominated operations (chart below) – not enough, clearly, but they’ve done it.
Importantly, in the case of the US banking crisis, the US Treasury recapitalized the banks. In Europe, you’ve got 17 economies that (at this time) must conjure up a plan to buffer their respective banking systems in the face of a Greek default, a Portuguese default, a failed ratification of the EFSF, etc. Alone this is not credible, but a euro-wide plan would be credible.
And here’s the problem: European banks face a very different risk than did US banks: sovereign risk via failed fiscal coordination.
Why sovereign risk is at the forefront of bank risk. In my last post, Linking Sovereign Risk to Corporate Credit Spreads in Europe, I argued that the contemporaneous underperformance of European utility and financial credit spreads reinforces the ‘sovereign risk’ element of current banking stress in Europe. In another post, I illustrated that European banks have increased their exposure to their sovereigns relative to traditional lending on the asset side of the balance sheet. Specifically, banks increased their exposure to the assets whose risk was rising across Europe, the sovereigns.
Another clue to the European bank crisis: It’s not a funding crisis.
I’ve highlighted why the European banking crisis is not a ‘subprime’ version of the US banking crisis. But why is it NOT a liquidity crisis? First, banks within the euro area have increased liquidity exposure, as illustrated by the ECB’s measure of ‘excess liquidity’ in the Eurosystem. The ECB has offered funding at a 1-week, 1-, 3-, and 6- month tenders. They’re even talking about a 1-yr facility for the next policy meeting.
Furthermore, while the ECB reopened FX swap lines and lengthened the tenor on the USD lines, it’s not clear to me that banks actually ‘need’ the dollars. As measured by the US Federal Reserve, foreign bank branches operating in the US hold near $900 billion in USD cash reserves on balance (not seasonally adjusted) – this USD cash buffer was just $50 billion before the 2008-2009 crisis.
I’ll admit that the euro area’s reliance on wholesale funding is humbling (see a nice chart on .pdf page 23 of France’s 2011 Article IV Report) . However, the buffers put in place at this time by both the ECB facilities and the build-up of USD reserves lead me to believe that this has more to do with the lack of sovereign coordination than any imminent funding crisis.
Another source of potential shortfall in liquidity in the monetary financial institutions of Europe (MFIs) are those MFIs labeled as money market funds (MMFs), or ‘other institutions’. In the US liquidity (and solvency) crisis, key non-bank players had no access to the Fed’s discount window. In some cases, they had no collateral to post. Europe may face this problem eventually. As a share of the total number of MFI’s, the MMFs and ‘other institutions’ constitute 19% of the total monetary financial network in August 2011. Since these institutions do not hold reserves with the ECB, they do not have access to the ECB’s lending facilities. I’ll have to think about this more.
This is a crisis of fear of sovereign risk amid a breakdown of coordination – and with good reason.
My view is that it’s not about the banks, per se, it’s about the sovereigns that implicitly guarantee the banks. At this time, there’s no credible “lender of last resort”, like was the Treasury in the 2008 US banking crisis. There’s the ECB – but that’s not a long-term solution unless it’s done in concert with the governments.
According to the Global Financial Stability Report (GFSR Septmeber 2011, .pdf link here) sovereign risks to the banks are both explicit and implicit in nature:
(1) direct exposure to the sovereign via eroding market value of sovereign assets (we all know this data).
Just 12% of sovereign exposure is held on the trading book, the rest is available for sale (AFS), 49%, and held to maturity (HTM), 39% (see Box 1.3 of Chapter 1 in GFSR report). In the case of HTM, German banks, for example, that bought at par (€100) Greeek debt that is now worth €43 at market is being held on balance at €100. The crisis has spread to Italy and Spain, so the stock of assets that need to be written down is growing.
(2) Interbank lending poses a risk (See chart to left, click to enlarge, and ECB for chart data ). In this manner, banks have indirect exposure to sovereign risk even if they have minimal explicit holdings. This is one reason that the average interbank rate (LIBOR) has been rising – banks don’t trust each other (see chart to left and click to enlarge).
(3) Margin calls rise as government bonds used as collateral see rating or potential rating downgrades. Likewise, banks face direct rating downgrade risk of the as asset quality erodes.
(4) Eroding implicit government guarantees on the liabilities side of bank balance sheets and ability to recapitalize writedowns on the asset side of bank balance sheets. This is big; and in my view, the driving force of bank risk at this time. As policy makers debate about what cannot be done, they’re missing a glowing opportunity to prevent a banking crisis (see Munchau’s article in the FT). Essentially, bond investors do not ‘believe’ that policy makers can individually address their own banks’ capital needs and imminent delevaraging (see my previous post on bank leverage) – a joint euro-wide effort is needed. Lack of credible coordination among the sovereigns has left banks wide open to speculative attack.
The pressure’s on. We’ll see if policy makers can understand what I see: this is not a liquidity crisis, this is a sovereign coordination crisis.
13 Responses to “Europe’s Banking Crisis Is No Longer a Liquidity Crisis, nor Is It a European Version of ‘Subprime’ – It’s a Sovereign Coordination Crisis”
Socialist sovereign debt cannot be repaid. It is not a crisis. It is a reality. Bankers are poor judges of risk.
when you say foreign bank branches operating in the US hold near $900 billion in USD cash reserves on balance – should you not narrow this down to European banks only rather than all foreign banks to check for stress only amongst European banks?
If this measure still demonstrates ample liquidity, why are euro dollar basis swaps moving more negative (becoming costlier to borrow dollars against 3 month euribor)?
A follow up on Aroon's question, isn't it possible the $900 billion has been accumulated as U.S. investors shift financial assets from the global financial system back to the U.S. while keeping ownership in a foreign country to avoid taxation? It would seem the push to allow another tax-reduced repatriation, similar in 2004, is being pushed for this reason.
As for the foreign banks, the Fed data (linked) does not provide a regional breakdown. However, based on the banks that I know around town (Boston) and in NYC, there is a large share of european banks in the sample (including UK). One could look at the balance sheets of the top 10 European banks to gauge assets in the US…
As for the euro dollar basis, perhaps it's counter party risk, I really don't know. All I do see is that the ECB swap lines have barely been drawn upon – that may change, but the lines should cover banks at least through the end of the year. Overall, banks may 'require' more liquidity from the ECB, but the supply is, theoretically, somewhat unlimited.
Are you referring to the Homeland Investment Act of 2005? I would not expect the flows to occur until after the corporate tax break is signed into law. Other than that, there is some evidence that QE2 drove some of the surge in cash balances of foreign banks in the US via differences in FdIC surcharges (from FT Alphaville, http://ftalphaville.ft.com/blog/2011/09/05/669051) and easy fed money <a href="http://(http://www.economonitor.com/rebeccawilder/2011/09/07/the-ecb-data-do-not-support-the-view-that-european-banks-are-moving-cash-assets-out-of-europe-and-into-the-u-s-its-the-feds-qe2-thats-all/):” target=”_blank”>(http://www.economonitor.com/rebeccawilder/2011/09/07/the-ecb-data-do-not-support-the-view-that-european-banks-are-moving-cash-assets-out-of-europe-and-into-the-u-s-its-the-feds-qe2-thats-all/):
"There may be other motivations beyond safety. Deposits at the Fed are unusually attractive for foreign banks because of the regulatory landscape. Borrowing money via deposits that don’t exact an FDIC surcharge, and depositing them at the Federal Reserve, earning 25 basis points, is much more attractive to a foreign bank with a US branch than it is to a US bank. That regulatory gap also provides insight into why foreign-related banks have maintained sizable deposits at the Fed."
Whatever the motivation, they seem to have at least a relatively rich USD cash buffer compared to 2007 (or any other year, for that matter).
[...] Wilder in EconoMonitor relates It’s a sovereign coordination crisis. Eroding implicit government guarantees on the liabilities side of bank balance sheets and ability [...]
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