Monday, December 19, 2011

Mr. Draghi: Eurozone banks have liquidity problems because they are insolvent

Over the last few weeks, the global central banks have setup a number of funding mechanisms to make sure that the Eurozone banks have access to liquidity should they not be able to rollover their debts held by the private sector.

Why would the Eurozone banks not be able to rollover their debts?

Because the private sector cannot independently determine if the banks are solvent or not and if they are insolvent, if the host country and the Eurozone will make good on the implicit guarantee of their investment; a legacy of the bailouts of 2008/2009.

The private sector knows the banks have losses.  The question is where do the losses reside.  A question that will still exist even if banks claim to have hit the 9% Tier I capital ratio as the private sector knows that banks have been able to hide losses as regulators practice forbearance.

In a Wall Street Journal article, Mr. Draghi tries to suggest that it is the other way around: the potential for liquidity problems is creating the solvency problem for banks.

Banks will experience a difficult period of funding constraints in the first quarter of next year and probably throughout all of 2012, and the ECB "wants to avoid a further slowdown in economic growth and a possible recession," Mr. Draghi said. The ECB is trying "to do its best" to avoid a credit crunch stemming from the lack of funding, he added. 
Avoiding a funding crunch is all the more important, since worries about banks' liquidity could easily turn into fears over their solvency, he said.
Banks are cutting back on lending and selling assets to reach the meaningless 9% Tier I capital ratio.  This is the source of the credit crunch.

The trigger for renewal of the ongoing solvency crisis is the simple fact that banks will not be able to shrink the asset side of their balance sheets as quickly as their liabilities mature.  As a result, they are going to have to raise funds from somewhere.

The ECB is the most likely source for funds because it just agreed to lend against any asset on a Eurozone bank's books.

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