by Don Alexander, MBA
Associate, RSD Solutions Inc.
Basic research is like shooting an arrow into the air and,
Where it lands, painting a target (Homer Adkins)
The euro is heading toward an abyss. The sovereign debt crisis is evolving into a full-fledged banking crisis with global consequences. Nicholas Veron, of the Peterson Institute, has written a short-article on issues facing European banks “Europe Must Change Course on Banks” (Dec. 19th).
The crisis is evolving along multiple dimensions. On the sovereign debt, Greece’s debt restructuring remains unresolved, and Italy and Spain face major refinancing needs in early 2012. Eurozone countries may have to refinance between euro 1.2-1.5 trillion in 2012. The Eurozone summit on December 9th, fell short of delivering a true fiscal union, and raised tensions within the euro area and with the United Kingdom. On the growth front, a possible deep and prolonged recession looms, especially as countries place emphasis on fiscal austerity.
The banking system is a crucial piece of the puzzle and epitomizes the contradictions of Europe’s experiment with monetary union. Since 2007, the system has exhibited gaps in risk management, and massive supervisory failures in some countries. The banks are exposed to an agency problem – they are under national control, but pose risks for the euro. To keep on favorable terms with local authorities, they are often buyers of last resort after failed auctions. In the past two years, deteriorating sovereign creditworthiness has increased the system’s fragility, especially since they depend on wholesale money markets for funding. CDS premiums remain elevated for European sovereign debt
Political affirmation of the integrity of the euro area banking system does not require new treaties, but major resistance comes from, among others, individual banks fearing the loss of national privileges or protections. However, the creation of a “banking union,” parallel to the fiscal union now advocated by German Chancellor Angela Merkel, would not mean the end of all national and local specificities. A euro-area-level banking policy framework that will transcend interdependences between banking and political structures at the national and local level is a necessary condition for the survival of the monetary union.
As the euro crisis continues to unfold, there is increasing risk that the crisis could move across the Atlantic. The near-term conduit from the banking system through money markets, derivatives or some other under radar surprise. A longer-term mechanism is through a severe credit contraction that could induce a global recession.
The problem for global banks, especially for European banks, is that Basel I and II encouraged banks to hold sovereign debt as risk-free. Basel III imposes more capital requirements and it will require additional euro hundred billions of capital over that suggested by recent stress tests. The question is how European banks can meet the new capital shortfalls without causing growth stagnation?
The immediate goal for European authorities is provide standardization of regulation across the Eurozone such as national interests do not subvert the euro. Long-term European banks have to be recapitalized without causing a severe credit contraction. It will require prudent central bank policy and cooperation between national regulators. The failure to implement prudent reforms could result in a near-term freeze in bank funding or a global recession. Neither outcome is provides a favorable target for a sustainable US recovery.
For more on this follow the link: http://www.piie.com/realtime/?p=2581
