Sunday, June 3, 2012

Spanish banking crisis

The ECB is forbidden by its charter to lend to insolvent banks. The Spanish banks are insolvent, and are suffering a fear-driven deposit outflow which threatens their liquidity. If the ECB stops lending to the Spanish banks, they will collapse and Spain will be forced to leave the euro. If the ECB continues to lend to what it knows to be insolvent banks, it will be blamed for its own insolvency. Spain does not have enough money to recapitalize its banking system.

Spain refuses to ask Europe for bailout money because they don’t want to submit to the austerity plan that comes with a bailout. Spain wants Europe to bail out its banks directly, which it refuses to do. The ECB, understandably, is becoming extremely angry at being asked to keep lending to insolvent Spanish banks. Mario Draghi has called for a union-wide bank support scheme, which Germany has (so far) nixed.

The periphery’s banking system is a big mess. The banks have lots of bad real estate loans from the bubble, they are generally dependent upon noncore funding, and they are all highly exposed to their sovereign’s bonds. They are not required to mark their government bond portfolios to market (for reasons that I don’t understand). Were they to do so, their book solvency would resemble their economic insolvency. But even with overvalued loans and bonds, no one is under any illusions about the strength of the banks of Greece, Cyprus, Italy, Spain, Portugal and Ireland. Few of them are really solvent, and thus few of them should be eligible for continued ECB funding. But they are all getting it.

Another European game of chicken: ECB versus everyone else. The problem is that the ECB has no conventional weapons, only the hydrogen bomb. They can jawbone and bang the table, but they can’t force Europe to make its banks solvent, and they can’t drop the big one. So, over time, the ECB’s insolvency grows. This is not a problem with respect to the fulfillment of the ECB’s role as central bank; central bank solvency is irrelevant to the conduct of monetary policy. (Central banks never run out of money.)  But in a Germanic world, an insolvent ECB is a problem, and is also a contingent liability of the Bundesbank. So it is not acceptable.

So who will blink first?  I guess it will have to be Spain, which will have to take the unwanted bailout. So the Spanish banks will be recapitalized, declared solvent, and go back on life-support from the ECB. Crisis averted.

So what is the longer-term prognosis for the eurozone? We will see the peripheral countries steadily replacing market liabilities (deposits, government bonds) with official sources (ECB loans to banks, EFSF and ESM loans to governments). Over time, the EU will become the periphery’s only creditor.

This is sustainable as long as Germany (Merkel, the Bundesbank) go along. They certainly don’t want to. Today Merkel said that she will only consider bailing out Europe in the context of a new federal treaty, which is nonstarter. So the limiting factor will be Berlin’s patience, and the patience of the German voters.

No comments: