Wednesday, September 21, 2011

21/09/2011: ESRB warns of contagion across euro area financial systems

The General Board of the European Systemic Risk Board (ESRB) held its third regular meeting today on September 21st, and here are the highlights.

In terms of assessing the current situation, the ESRB stated that "since the previous ESRB General Board meeting on 22 June 2011, risks to the stability of the EU financial system have increased considerably. Key risks stem from potential further adverse feedback effects between sovereign risks, funding vulnerabilities within the EU banking sector, and a weakening of growth outlooks both at global and EU levels."

So what ESRB is saying here is that the crisis has completed full circle: if in 2008-2009 transmission of risks worked from insolvent banking sector to insolvent sovereigns and (technically always solvent) monetary authorities via liquidity supports & recapitalization schemes, since 2010 through today the risks have flown the other way - from insolvent sovereigns to insolvent banks via bust bond valuations. The only question that remains now, is where the vicious spiral swing next. In my view - at least in anti-taxpayer, anti-competition Europe it will force taxpayers to directly recapitalize the banks (see IMF's latest calls and the rumor that France is about to go this way) to protect incumbent banking license holders from bankruptcy, receiverships and competition from healthier and new banks.

"Over the last months, sovereign stress has moved from smaller economies to some of the larger EU countries. Signs of stress are evident in many European government bond markets, while the high volatility in equity markets indicates that tensions have spread across capital markets around the world. The situation has been aggravated by the progressive drying-up of bank term funding markets, and availability of US dollar funding to EU banks had also decreased significantly. In that context, central banks have decided on coordinated US dollar liquidity-providing operations with longer maturities."

Nothing new in the above, but it is nice to see an honest admission of the ongoing liquidity crisis. Now, recall that I have said on numerous occasions that bank runs start with a run on the bank by its funders. This is what we term a liquidity crunch - interbank markets freeze, banks bonds funding streams dry out. Only after that can the depositor run develop, usually starting with corporate depositors. Funny enough - the ESRB wouldn't say it out-loud, but in effect it already called in the above statement a bank run in funding markets. Worse, we also know - from the likes of Siemens transaction reported here ( ) - that to some extent (unknown) corporate deposits run might be taking place as well. Next?

"The high interconnectedness in the EU financial system has led to a rapidly rising risk of significant contagion. This threatens financial stability in the EU as a whole and adversely impacts the real economy in Europe and beyond."

So, per ESRB:
"Decisive and swift action is required from all authorities. In the immediate future this includes:
* implementing, fully and rapidly, the measures agreed upon at the 21 July meeting of the Heads of State or Government of the euro area;
* adopting sustainable fiscal policies and growth-enhancing structural measures so as to achieve or maintain credibility of sovereign signatures in global markets; and
* enhancing the coordination and consistency of communication.
Now, I am not a fan of July 21 decisions, primarily because they do not address the core issue of the crisis - too much debt in the system and too little growth. EFSF purchasing sovereign bonds and lending to insolvent states is not going to reduce the debt pile accumulated by European Governments. Nor will extending maturity and lowering interest rates on its loans help improve economic situation in PIIGS and beyond. So I would disagree with ESRB on the first bullet point.

Calling for adoption of sustainable fiscal policies and growth enhancing measures is like telling a person sinking in a bog to pull harder on his hair. Fiscal sustainability is not being delivered in any of the PIIGS so far, and there is absolutely no appetite for any Government in Europe to take properly drastic measures required to get their finances on sustainable path. Even the very definition of sustainability used by EU is a mad one (let alone not a single state actually adhered to it so far with exception of Finland). A deficit of 3% pa means that you get to 100% debt/GDP ratio in longer time than with a deficit of 5% pa. But you will still get there, folks. Debt to GDP ratio of 60% is only sustainable if, in the environment of 3% 10-year yields your economy expands by more than 1.8% pa (assuming no population growth and no amortization and depreciation under balanced budget). That has not happened in the euro zone in any single 10 year period since we have full data for its members.

Growth-enhancing measures adoption is another case of pure 'wishful' thinking. In most of the Euro area and indeed in the EU Commission, this usually means more subsidies and more state spending. In parts of Central and Eastern Europe it usually means promoting real private sector competition and investment. Of course, we know who weathered the storm best in the last two recessions. But, hey, ESRB wouldn't make a call as to what it means by this "adopting... growth-enhancing measures" despite the fact that much of "growth enhancements" unleashed on euro area economies in recent past is precisely what got us into the current sovereign debt mess in the first place.

As per its last bullet point, one starts to wonder if ESRB is going down the slippery line of 'rhetoric ahead of action'. What does "enhancing the coordination and consistency of communication" mean? All of the EU policymakers 'speaking with one voice'? Curtailing or otherwise minimizing dissent? Controlling information flows? What the hell, pardon my French here, does it really mean, folks?

On a beefy ending, ESRB prescribes that: "Supervisors should coordinate efforts to strengthen bank capital, including having recourse to backstop facilities, taking also into account the need for transparent and consistent valuation of sovereign exposures. If necessary, this could benefit from the possibility for the European Financial Stability Facility to lend to governments in order to recapitalise banks, including in non-programme countries."

I am sorry to say this, but if anyone reading this is going to vote in the Dail on the European Financial Stability Facility and Euro Area Loan Facility (Amendment) Bill 2011 you really have to understand this statement. In effect, ESRB here welcomes loading of the risks of insolvent banking systems - including in non-programme countries - into one single facility, the EFSF, which will have preventative powers to intervene in the markets to buy distressed debts of banks and sovereigns. In a sense, EFSF will become a super-dump - a motherload of super toxic financial refuse from both radioactively insolvent sovereigns and biochemically toxic banks. You wouldn't want THIS anywhere near your local constituency.

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