EUROPE´S BANKING BLINDFOLDS / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( A MUST READ )

REVIEW & OUTLOOK

MARCH 11, 2011.

Europe's Banking Blindfolds

Did someone say sovereign debt risk?.
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Europe's still-simmering sovereign-debt troubles bubbled back into view yesterday, as a Moody's downgrade of Spanish debt sparked a global stock-market sell-off. The euro also fell 0.76% against the dollar and the cost of insuring against sovereign default in Europe ticked up.


Moody's country report spooked the markets by citing the possibility that Spain could need as much as €120 billion to recapitalize its banks, which are still dominated by relatively small and opaque savings banks, or cajas, that Madrid is trying to consolidate and reform. After European markets closed yesterday, the Bank of Spain announced that Spain's banks need an additional €15 billion in capital now.


Whatever the final number, Spain's banking woes highlight a truth that Europe's leaders would rather suppress: Europe's sovereign debt troubles and the solvency of its banks are inextricably linked.


In Spain's case, as with Ireland before it, the bailout question will turn on how expensive it will be to save its banks. But the link runs the other way too. Thanks in part to the way regulators set capital requirements, all of Europe's big banks are heavily invested in European sovereign debt.


A big default in Europe would immediately jeopardize the solvency of a number of Europe's big commercial banks, which is the reason Ireland was forced to make whole most of the bondholders in its failed private-sector banks. The bailout, in effect, recapitalized Continental banks, and Irish taxpayers got stuck with the bill.

A sovereign default would trigger big losses in Europe's banks, which is no doubt why last year's bank stress tests refused to contemplate such a scenario. This year's tests will also ignore the 85% of sovereign debt that banks list as "held to maturity," and no default scenario will be tested. In U.S. education, they call that the soft bigotry of low expectations. But ignoring the link between the solvency of banks and sovereigns won't make it go away.


Ireland offers the clearest example of how an insolvent banking system can rapidly take down the otherwise healthy economy that guarantees it. Spanish banks are among the most exposed to risk in Portugal, which is busy putting on the same brave face that we saw from Dublin and Athens before they accepted billions in European rescue funds. German and French banks in turn are heavily exposed to Spanish risk, and European banks' total exposure to Spain alone exceeded €700 billion as of last September. The big difference is that Spain might be too big and expensive for Europe to bail out.


Spain has done better than most in Europe to disclose its banking problems, and the Bank of Spain's work on recapitalizing the banks has been a model of transparency relative to the rest of the Continent. But even Spain has been reluctant to ask what happens if, say, real-estate prices continue to fall. Another stress-test whitewash will do nothing for investor confidence in European government debt, but a much fuller disclosure of who's exposed to whose risks might well.


Euro-zone finance ministers meet today to discuss the terms under which they will continue to prop up basket-case economies after 2013. They would do more to restore confidence by coming clean about the exposure of their banks to sovereign debt.


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