Is the global banking system staring into the abyss?

Jeremy Warner wrote an interesting column in the Telegraph in which he asked if Europe's banks are staring into the abyss.

Are US banks also looking into the abyss given the interconnectedness of the global banking system?  The fact that Treasury Secretary Tim Geithner is flying to Europe to put pressure on European governments to bailout their banks and deal with the sovereign debt issue strongly suggests they are.

The fact is since August 9, 2007 when the solvency crisis began market participants have not been able to tell which banks are solvent and which are not.  If they could, do you think that the US money market mutual fund industry would be reducing its exposure to European banks given the limited opportunities to earn money in the US under the Fed's zero interest rate policy?

Regular readers know that markets hate uncertainty and not knowing who is solvent and who is insolvent is a major source of uncertainty.

Markets do not hate insolvent banks as previously documented in the discussion of Security Pacific and its loans to Less Developed Countries in the mid-80s.  Markets understand that solvency is determined by the market value of the assets on the bank's balance sheet exceeding the book value of its liabilities.

Markets understand that some insolvent banks have the capacity to generate the earnings necessary to restore their solvency and some insolvent banks do not.  Insolvent banks in the former category markets are willing to continue funding.  Insolvent banks in the latter category the market would expect would be closed.

Had policy makers in 2008 and 2009 taken this into account, perhaps they would not have transformed a bank solvency crisis into a bank and sovereign solvency crisis.

Now markets not only have the uncertainty concerning which banks are solvent and which are not, but they also have the uncertainty of which countries are going to destroy their own sovereign solvency in an effort to prevent the market from discovering which banks the country hosts are solvent and which are not.

Ireland has become a classic example of why it is important to get the facts on solvency first before putting the sovereign solvency on the line.

Where now for European banks? Sir Howard Davies, former chairman of Britain's Financial Services Authority, said on BBC Radio's Today programme on Tuesday morning that he thought the French government was only days away from having to recapitalise the country's banking system for a second time. It's hard to disagree. 

The panic seems to have been temporarily stemmed by a statement from BNP Paribas to the effect that it wasn't having the problems widely reported of finding dollar funding.

Actually, it was the additional disclosure that accompanied the statement as nobody trusts the claims of the regulators (see widely discredited stress tests) or banks anymore.

There was also an emphatic denial of discussions over state intervention. But no-one is kidding themselves. Italy had to pay the highest spread since joining the euro to sell its bonds on Tuesday. There are growing fears over whether Europe's largest borrower can stay the course. 

The eurozone sovereign debt crisis is meanwhile exacting a devastating toll on the European banking system as a whole, the UK included. With their high exposure to eurozone debt, the problem is particularly acute for the French banking goliaths, BNP Paribas and Societe Generale.... 

Collectively, French banks have €56bn of Greek sovereign bonds alone. They've so far only written down this Greek debt by around 20pc, or in line with the restructuring agreed at the time of the last bailout. 

That's nowhere near mark to market....

Greece is already effectively a cash only economy. Most forms of credit has effectively dried up, the Greek banking system is finished, and capital controls to prevent what little money that remains from leaving the country are surely only a matter of time. European banking must prepare for the worst as far as Greece is concerned. 

As for the remainder of the eurozone sovereign exposure, there's been no write down at all among banks on these bonds. If there's a wider problem of default, the bad debt recognition has yet to come. 

How come European banks have got so much of the stuff? Well ironically, this is one lending decision gone wrong that the banks cannot be blamed for. In response to the original banking crisis, regulators ordered banks substantially to increase their liquidity buffers. Government bonds are generally viewed as the most liquid and least risky assets to hold, so that's where the money went. 

That these regulatory obligations also helped governments fund their ever growing deficits is by the by. In any case, nowhere is the law of unintended consequences more in evidence than in financial regulation. By seeking to address the last crisis with greater liquidity buffers, regulators succeeded only in sowing the seeds for the next one. 

A banking crisis that transmogrified into a sovereign debt crisis now shows every sign of transmogrifying back into another banking crisis....

When the banking crisis first broke, Europeans tended to regard it as wholly an Anglo-Saxon problem. There was some recapitalisation of French and German banks that went on in late 2008, early 2009, but it wasn't nearly as big as in the UK and the US, and within a year, the French banks had in any case largely repaid all their state support. Problem over, it was thought. 

This is what the regulators said at least.

The same refusal to face up to underlying solvency concerns continues to dominate Contintental attitudes to the crisis. There is a collective sense of denial. 

BNP for one insists that it is in nothing like the same poor shape as many UK and US banks back in 2008. Profits are still buoyant, delinquency subdued, and capital more than adequate, BNP insists. Unfortunately, that's not what the markets are saying.

Market participants know that profits, like bank capital, are an easily manipulated accounting construct.  For example, by not setting aside reserves for the Greek debt, profits and therefore book capital are overstated.

Since the banks do not disclose current asset and liability-level data, market participants are forced to guess what the banks' exposures are.  From here they try to determine if the banks are solvent or not.

Both BNP Paribas and Societe Generale recognized that they need to disclose much more information if market participants were to believe their claims (the disclosure allows for market participants to trust, but verify).

Record quantities of European term funding are set to mature in the first quarter of next year. It's not clear that the European Central Bank can cope with the sort of liquidity support that banks will require if markets refuse to refinance it.

Why would the markets refinance this debt without disclosure of current assets and liability-level data.  Without this data, markets would essentially be buying opaque toxic securities.

Europe's financial and monetary system is falling apart. 

Since French banks are widely thought of as essentially arms of the French state, is there actually any point in recapitalising them? ... Why not then just make this implicit support explicit? 

You only need to take one look at what happened to Ireland to see why. In the early days of the crisis, the Irish government promised to stand behind all banking liabilities. By doing so, it ended up pushing the entire country into bankruptcy.

The time has come for disclosure.  Depending on what disclosure shows then a solution can be implemented.