With Europe’s politicians continuing to stumble from one summit to another without a realistic plan for resolving the sovereign debt crisis, the one European institution that is keeping the entire system afloat is the European Central Bank. The ECB gave the capital markets a boost earlier this month when it announced that it would provide virtually unlimited liquidity to Europe’s ailing banks in the form of low-interest loans of up to three years. Data released this week show that Europe’s banks have accepted the ECB’s offer with enthusiasm; 523 banks borrowed nearly half a trillion euros according to Reuters.
This was an enormous step forward, but a little perspective is necessary here. The move more or less eliminates the risk of a disorderly default by a major bank—a “Lehman Brothers moment,” if you will. But it most assuredly does nothing to assist Europe’s indebted countries, nor does it do anything to mitigate the risk that a sovereign default could turn the capital markets upside down.
French President Nicolas Sarkozy effectively showed the rest of the world his cards when he suggested that banks could borrow unlimited funds from the ECB under this arrangement and then use them to purchase the government bonds of their respective home countries. In theory, this could work. Spanish and Italian banks could be “lenders of last resort” to their cash-strapped government, stabilizing the bond markets and bringing yields back down to earth.
But if this is what Mr. Sarkozy is proposing as a “solution” to the debt crisis, I fear the French President may be in for a disappointment.
It was excessive purchasing of sovereign debt that got banks into this mess to begin with. If government bonds were “risk free,” then buying them with cheaply borrowed money makes a lot of sense. But as recent events have proven, European debt is anything but risk free. What banker in his or her right mind would continue to throw good money after bad? And how would this be in the best interests of their shareholders?
Meanwhile, European banks are already under enormous pressure to shrink their balance sheets, reduce their risky assets, and deleverage themselves…and to do this while simultaneously keeping the lifeblood of credit flowing to European companies and consumers. Bank funds used to buy government bonds are bank funds that cannot be lent in the real economy. And given that Europe may already technically be in recession, is this what Mr. Sarkozy wants?
And so the crisis rages on.
For banks—or any investors, for that matter—to be buyers of Italian and Spanish debt, they need to be confident that they will get their money back. And for this to happen we need to see one of two developments, both of which are currently off the table:
- A massive increase in direct buying of the troubled countries’ sovereign debt by the European Central Bank on a scale big enough to drive down interest rates.
- Some sort of “Eurobond” scheme that shares liability across the Eurozone.
The proposed EU treaty changes that would enforce budgetary discipline would also do a fair bit to repair shattered confidence in the market, though even this alone is not sufficient without one or both of the options above.
Until Europe’s leaders accept what the markets are currently screaming at them, we can expect more months of on again, off again volatility. Brace yourself; it’s going to be a wild ride.
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