FRENCH BANKS COULD TIP EUROPE INTO A FULL-BLOWN BANKING CRISIS / THE FINANCIAL TIMES COMMENT & ANALYSIS ( A MUST READ )

French banks could tip Europe back into a full-blown banking crisis

Mohamed El-Erian

September 22, 2011Print


Conventional wisdom may now be only half right when it comes to solving Europe’s mess. Fixing the sovereign debt problem is still necessary, but it may no longer be sufficient. Europe must also move quickly to stabilise the banks at its core in ways that go far beyond what the European Central Bank announced on Wednesday. As senior BNP Paribas executives prepare to tour the Middle East in an attempt to raise fresh funds and shore up confidence, other banks must also show greater urgency and seriousness in dealing with capital and asset quality shortfalls.

Much of the discussion on the crisis is based on the assumption that sovereign debt is both the problem and the solution. Initially, this was correct. The combination of too much debt and too little growth pushed the most vulnerable countries (Greece, Ireland and Portugal) into a classic debt trap. Timid policy responses then fuelled contagion waves that undermined other sectors.


The problem today has become much more complicated. In addition to being on the receiving end, some of these sectors have become standalone sources of regional dislocations.


Italy is, of course, the most visible example. Interest rates on what is the third largest government debt market in the world remain stubbornly high in spite of persistent market intervention by the ECB. Wednesday’s rating cuts of some of the country’s leading banks, following Standard & Poor’s downgrade of the country’s sovereign debt on Monday, complicates matters.


Yet, as notable as this is, it is not the most immediately threatening issue for a global economy that, in the words of Christine Lagarde, IMF managing director, has entered “a dangerous phase”. The rapidly burning fuse is in the European banking system, particularly in France, and Europe is getting very close to yet another tipping point.

The facts are striking and worrisome. Private institutions around the world, and even some public ones, have sharply reduced short-term lending to French banks. Credit markets now put their risk of default at levels indicative of a BB rating, which is fundamentally inconsistent with sound banking operations. Bank equity now trades at a 50 per cent discount to tangible book value on average. To make things worse, the ratio of market capital to total assets has fallen to 1 – 1.5 per cent (compared with six to eight per cent for healthier banks).


These are all signs of an institutional run on French banks. If it persists, the banks would have no choice but to delever their balance sheets in a very drastic and disorderly fashion. Retail depositors would get edgy and be tempted to follow trading and institutional clients through the exit doors. Europe would thus be thrown into a full-blown banking crisis that aggravates the sovereign debt trap, renders certain another economic recession, and significantly worsens the outlook for the global economy.


So far neither the authorities nor the banks have done, or are doing enough to stop – let alone reverse – this trend. While the ECB has stepped in to offset the liquidity crunch, including by relaxing collateral requirements to make it easier for banks to access the central bank’s repo window, capital cushions and asset quality remain unaddressed. As a result, Europe is on the verge of losing control of orderly solutions to its debt crisis.


To counter this, fiscal authorities and banks must work with the ECB on three immediate, simultaneous and drastic measures. They must inject capital through public-private partnerships, including through Tarp-like mechanisms, present a realistic assessment of the asset side of the balance sheet and enhance depositor protection. Greater burden sharing with the private sector may also prove necessary.


Through the bitter experience of the last two years, Europe now understands that a sovereign debt problem is difficult to solve. It must now realise that the challenges and costs to society multiply astronomically when this is accompanied with a banking crisis; and it must act accordingly.
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The writer is the chief executive and co-chief investment officer of Pimco.

Response by George Magnus


Mohamed El-Erian’s take on the European sovereign debt crisis, now lapping the shores of the French banking system, is unquestionably right, but I would go further. The interconnectedness between the deteriorating creditworthiness of sovereign states and of banks has been the elephant in the room that European policy makers and European Central Bank officials have refused to see since the Greek crisis began at the end of 2009. If they had summoned the courage to explain this to voters a year ago, the cost of recapitalising the banks would have been significantly lower than the €300-500bn that it would now take – depending on loss and recovery rate assumptions for sovereign debt.


The fact that this fault line has now reached into France is very worrying. French banks hold more Greek debt than any other European nation, and today’s reports that BNP Paribas is seeking to raise capital in the Middle East and urging regulators to conduct (yet another) stress test is testament to both its own vulnerability – its exposure to peripheral sovereign debt including Italy amounts to over three fifths of its tangible equity – and also to the urgency of the wider recapitalisation programme.


I regard bank recapitalisation and a robust and open-ended commitment by the ECB to buy Italian and Spanish bonds as a double-headed sine qua non for ending the European bond market and sovereign financing crisis. The existential issues that need to be addressed for a viable Eurozone can be left until later. But they can’t if the bond market crisis is not resolved quickly. The time for incremental and technical changes to ECB and other policies and instruments is, to use banking parlance, long past due. And while I agree with Mr El-Erian’s policy prescriptions, it is surely not alarmist to say that if the political divisions and lack of determination in policy circles remain as now, we will surely hurtle to our own Kreditanstalt moment – the 1931 collapse of Austria’s largest bank which was how that appalling decade started.
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The writer is senior economic adviser at UBS Investment Bank.