Failure to solve banking crisis returns to haunt markets

In a Telegraph column, Phillip Inman observes that banks are in a credit crunch again.

Broken banks are a problem that affect all western nations. European banks must raise about $100bn this year to maintain and in some cases boost their capital buffers and many could struggle. Investors are less keen on banks than a year ago as profits slide and economies slip back into recession. 

In the US, Bank of America has seen its share price sink back to post Lehman levels, turning $50 a share before 2007 into less than $7 a share. It may need to raise $40bn to $50bn to meet regulatory demands for higher capital now the mortgages on its books are clearly worth less than the bank says they are. 

German and French banks, despite their bluster, are in an equally parlous state. 

Banks are struggling to get credit insurance on dealmaking and many have withdrawn from interbank lending forums. These stroke-inducing levels of anxiety affecting the banks feel like a re-run of 2008. 

Lars Frisell, the chief economist at Sweden's central bank [and a member of the Basel Committee for Banking Supervision], said last week it wouldn't "take much for the interbank market to collapse", bringing a fresh credit crunch. 

A Bloomberg article discussed this phase of the credit crisis.

Four years to the month since the global credit crisis began, European lenders remain dependent on central bank aid, plaguing markets and economies worldwide. 

Emergency steps such as unlimited loans from the European Central Bank are keeping many banks in Greece, Portugal, Italy and Spain solvent and greasing the lending of others, while low interest rates and debt-buying are containing borrowing costs. Such aid is needed as concerns about slowing economic growth and sovereign debt prompt banks to curb lending, stockpile dollars and hoard cash in safe havens. 

“I’m not sleeping at night,” said Charles Wyplosz, director of the Geneva-based International Center for Money and Banking Studies. “We have moved into a new phase of crisis.” 

Central bankers rescued financial firms after the collapse of Lehman Brothers Holdings Inc. in 2008 by providing limitless funding of as long as a year. While they treated the symptom -- a lack of ready cash -- politicians, regulators and bankers in Europe have proved unable to cure the root cause: some European lenders are at growing risk of insolvency. 

As noted by Mr. Inman, the issue of solvency is not limited to Europe.

This blog has repeatedly observed that the focus of policy makers from 2008 onward has been to treat symptoms and not to cure the root cause of bank insolvency.

The tremors, the biggest since Lehman’s collapse, were triggered by European governments’ continuing inability to stop the sovereign debt crisis from spreading beyond Greece, Portugal and Ireland to Italy and Spain. Renewed signs of economic weakness globally and the downgrading of U.S. debt by Standard & Poor’s rekindled concern about the quality of all government debt. 

The signs of distress are widespread and mounting: Banks deposited 128.7 billion euros ($186 billion) overnight with the ECB yesterday, more than three times this year’s average, rather than lend the money to other firms. Banks also borrowed 555 million euros from the Frankfurt-based ECB’s overnight marginal lending facility, up from 90 million euros the day before. 

... The extra yield investors demand to buy bank bonds instead of benchmark government debt surged to 302 basis points yesterday, or 3.02 percentage points, the highest since July 2009, data compiled by Bank of America Merrill Lynch show. The cost of insuring that debt against default surged to a record today. The Markit iTraxx Financial Index linked to senior debt of 25 European banks and insurers rose to 252 basis points, compared with 149 when Lehman collapsed.

It was the specter of government debt turning toxic that has revived the liquidity crisis policy makers had tried to stop in 2008. As speculation grew that European banks would have to write down their holdings of more governments’ debt after a Greek default, lenders pulled funding to those banks that held the most peripheral debt. It also raised concern European governments would struggle to afford a further bail out of their banks, because both the state and the lenders had failed to reduce their borrowings since the onset of the crisis. 

“The debt has been transferred from the banks to the sovereign, but it hasn’t actually been eradicated,” said Gary Greenwood, a banking analyst at Shore Capital in Liverpool. “Until the sovereigns get their balance sheets in order, then these concerns are going to remain.” 

Funding markets have seized up as investors speculate that sovereign debt writedowns are inevitable. Banks in the region hold 98.2 billion euros of Greek sovereign debt, 317 billion euros of Italian government debt and about 280 billion euros of Spanish bonds, according to European Banking Authority data. 

The difference between the three-month euro interbank offered rate, or Euribor, and the overnight indexed swap rate, a measure of banks’ reluctance to lend to each other, was at 0.66 percentage point today, within 4 basis points of the widest spread since May 2009. 

“The central bank is the only clearer left to settle funds between banks,” said Christoph Rieger, head of fixed-income strategy at Commerzbank AG (CBK) in Frankfurt. “There is a mistrust between banks in general, between regions and with dollar providers overall.” 

... “Banks are becoming more nervous about being exposed to other banks as they hoard liquidity and become more suspicious of other banks’ balance sheets,” Guillaume Tiberghien, analyst at Exane BNP Paribas (BNP), wrote in a note to clients on Aug. 19. 

Regular readers know that it is only when all financial institutions disclose their current asset and liability-level data that it is possible to end the cycle of banks withdrawing liquidity from the market whenever they become worried about other banks' balance sheets.

With disclosure, banks can properly assess the risk of other banks and set both the amount and price of their exposures.

By contrast, banks in the U.S. are “flush” with liquidity, loan loss reserves and capital, Goldman Sachs Group Inc. analyst Richard Ramsden wrote in an Aug. 6 report. Large commercial banks combined holdings of cash and securities at large have climbed to 30 percent of managed assets, up from 22 percent at the start of the U.S. financial crisis in October 2007, Ramsden wrote, citing Federal Reserve data. 

Bank of America would appear to contradict the Goldman report as the bank is publicly arguing with critics over whether it needs to raise additional capital or not.

... Banks’ woes are again thrusting central bankers to the fore ....  After increasing its benchmark rate twice this year to counter inflation, the ECB this month provided relief for banks by buying Italian and Spanish bonds for the first time, lending unlimited funds for six months, and providing one unnamed bank with dollars to satisfy the first such request since February. In doing so, it’s maintaining a role it began in August 2007 when it injected cash into markets after they began to freeze. 

... The central bank is acting in part because governments have yet to ratify a plan to extend the scope of a 440-billion euro rescue facility to allow it to buy bonds and inject capital into banks. Markets tumbled last week on concern policy makers aren’t acting fast enough. 

... the ECB should eventually try to hand over fire-fighting duties either to governments, who would then inject capital into financial firms, or national central banks, who could provide short-term loans to lenders. 

Longer-term solutions may involve the restructuring the debt of cash-strapped nations in a way that doesn’t roil bank balance sheets, potentially in lockstep with a European version of the U.S.’s Troubled Asset Relief Program. 

Without current asset and liability-level disclosure, the only solutions available are bailouts.

With current asset and liability-level disclosure, other solutions become available.  For example, once the facts of a bank's insolvency are known, it could be allowed to continue operating, but with the requirement that it retain all its earnings until it is solvent again.

Lena Komileva, Group-of-10 strategy head at Brown Brothers Harriman & Co. in London, said the central bank may have no option but to extend the backstop role it is playing for periphery banks to lenders elsewhere. Refusal to do so would risk a European bank default by the end of the year, she said. 

“Markets are back in uncharted territory,” said Komileva. “The crisis is a whole new story now.”