Europe's banks are addicted to ECB's money

Der Spiegel carried an interesting article that identifies the lack of trust in the financial system as the cause of many of the symptoms, like frozen interbank lending markets and bank runs, that exist today.  It observes that while the ECB can provide enough money to replace the normal money markets, this does not address the issue of restoring trust.

The article confirms what your humble blogger has been saying since the beginning of the financial crisis.

The only way to restore trust in banks or structured finance securities is if they provide ultra transparency.  For banks, this means disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.  For structured finance securities, this means disclosing on an observable event basis what is happening with the underlying collateral.

It is only with this disclosure that market participants have the information they need to independently assess the risk of the banks or structured finance securities.  Based on this analysis, market participants can adjust the amount and price of their exposure and make buy, hold, sell decisions based on the prices shown to them by Wall Street.

For Kleanthis Papadopoulos, chairman of Greece's TT Hellenic Postbank, the situation is not looking good. "I can't give any new credits," he admits soberly. 

Many Greeks are withdrawing their euros from the country's banks. To make matters worse, insurance companies and other financial institutions have long since stopped giving any money to Greek banks. As a result, the country is simply running out of cash...

Greeks say that anyone intending to withdraw several thousand euros in cash from their bank would be well advised to warn them in advance.

For months, this blog has been documenting the run on the Greek banks.

This dearth of money will prompt the European Central Bank (ECB) to once again open its seemingly bottomless coffers this week and grant generous loans....

The fact is that so long as a central bank is willing to provide liquidity, banks can remain in business.

What drives the run on the Greek banks is not just questions about their solvency, but also questions about whether the government can perform on its deposit guarantee.  The Eurozone could have ended the bank run by backstopping the deposit guarantee.

When asked how long such a policy could be successfully pursued, ECB President Mario Draghi said that it was only "temporary." In his view, the financial system faces an emergency situation -- and therefore requires emergency aid. 

But when does an emergency become business as usual? And how big is the danger that Europe's banks will simply forget how to stand on their own two feet if they are continuously being propped up?

It's been years since the banks were last able to easily access money. 

"Before the Lehman Brothers collapse, liquidity was simply there," says Stefan Best, an analyst at the rating agency Standard & Poor's. At the time, banks readily lent each other billions at low interest rates -- overnight as well as for longer periods. It was an era of widespread trust.

Please re-read the highlighted text and recall that before deposit insurance the sign of a bank that could stand on its own two feet was a bank that provided ultra transparency!

The issue is not just that banks are addicted to central bank funding and government bailouts, but that there is no policy in place that restores trust.  Without trust, there is no possibility of ending bank reliance on central bank funding and government bailouts and replacing this funding with money from the markets.

There was such an abundance of money that banks became less and less reliant on customer deposits. 

[Until] the 1990s, banks primarily recapitalized using funds that individuals and companies had squirreled away on their accounts. In 1997, the gap between deposits and loans granted within the euro zone was only €44 billion. 

During the 10 years that followed, this disparity increased to €1.3 trillion.  

The banks easily plugged the hole using funds that they acquired on the financial markets....

A hole that the ECB has to fill if financial markets are unwilling to lend to banks.

The fact that this situation changed dramatically is thanks to managers like Richard Fuld and Georg Funke, the former CEOs of the US investment bank Lehman Brothers and Germany's Hypo Real Estate (HRE) respectively. 

They invested money which they borrowed short-term at low interest rates in risky and protracted mortgage deals. As long as the profits continued to flow, nobody asked about the risks.

Actually, market participants relied on the regulators since the regulators had ultra transparency into the banks exposure details (think bank examiners) and the market participants did not.

More importantly, market participants assumed that the regulators knew how to assess this exposure detail and understand its implication for the risks the firms were taking.

Finally, market participants assumed that the regulators would convey their assessment of risk to the market in a timely manner or take steps to keep the risk the banks were taking in line with regulatory pronouncements.  After all, who can forget Alan Greenspan's comments on how financial innovation had made the banks less risky.

But after the collapse of Lehman Brothers and HRE in the fall of 2008, the financial industry's trust was shattered.

Trust was shattered not only in the banks, but in the regulators!  Subsequent actions by the regulators, like the stress tests, have only confirmed why the regulators' assessment should not be trusted (recall that European banks have failed within weeks of the last two stress tests).

Market participants have reacted by going on a "buyer's strike" until such time as they are provided with ultra transparency so they can independently assess the risk of each bank for themselves.

The interbank lending market dried up...

Predictably because the data was not available to assess the risk of making the loans.

Under the Japanese model for handling a bank solvency based financial crisis, regulators blessed banks hiding losses on and off their balance sheets.  Each bank knows what it is hiding and as a result is reluctant to lend to another bank.

[Central] bankers ... became paramedics who eagerly rushed to the aid of ailing banks with each new crisis -- continuously increasing the dosage in the meantime. 

Today, euro-zone banks owe the ECB some €796 billion. 

"The ECB's cash injections have significantly reduced the danger of refinancing bottlenecks and a credit crunch," says Stefan Best, the Standard & Poor's analyst. 

But how long can this policy of almost free money continue to work?

In Japan, they have been pursuing this policy of almost free money for 2+ decades.

ECB President Draghi is hoping that the situation will resolve itself on its own. 

Since the beginning of the year, he says, the banks have again been increasingly borrowing via their normal financing channels....

There is no reason to believe that the situation will resolve itself on its own.  The lesson of the financial crisis is the need for market participants to do their own homework (a point that US Treasury Secretary Hank Paulson made).

Without ultra transparency, it is impossible to do the homework.

Citing an increase in borrowing via normal financing channels is a bit misleading given the dependence of the financial system on life support programs like the ECB's Long Term Refinancing Operation.  Perhaps access to these financing channels is simply investors reasoning that the ECB will provide funds in the future to repay them at maturity.

With the latest round of three-year loans granted by the ECB, the central bank is charging a rock-bottom interest rate of just 1.0 percent. Critics argue that this is like distributing free heroin to junkies. 

"If the ECB continues in this vein, we'll soon be able to shut down the normal money markets," says Hans-Werner Sinn, head of Germany's influential Ifo economic think tank.

The normal money markets have been shut down since the start of the financial crisis.  The only way to reopen them is requiring ultra transparency.

There is a long list of possible risks and side effects. 

Draghi's cheap money is also keeping financial institutions afloat that simply don't earn enough to cover their financing costs. 

The ECB's money is even paving the way for deals that in reality are too risky.  However, the price for such risks is blurred when a central bank continuously maintains artificially low interest rates. 

By definition, central banks maintaining artificially low interest rates (think zero interest rate policies) distorts the pricing of risk.

Central banks hope that this mis-pricing of risk leads to economic activity.

This is a case of hope triumphing over experience.  As shown by Japan which has followed artificially low interest rate policies, their GDP was lower in 2010 than it was in 1995 (Wikipedia - Economy of Japan).

Draghi's prescription for the crisis is also "a recipe for a new speculative bubble," says Uwe Burkert, head of credit analysis at Landesbank Baden-Württemberg, a state-owned regional German bank. 

In Germany, for instance, rates on real-estate financing loans are about as low as they have ever been. In its most recent monthly report, the German central bank, the Bundesbank, noted a "marked price reaction on the housing markets."...

Interest rate expert Uwe Burkert points to an additional risk that concerns the general public: Interest payments on life insurance policies are already declining from year to year. 

"The ongoing low interest rates are insidiously eating away at people's pensions," he argues. Since money is no longer circulating normally, the entire economic system is going off the rails....

Apparently Uwe Burkert was channeling his inner Walter Bagehot and seeing interest rates below 2% as causing a problem with the entire economic system.

It is important to note that the low interest rate policies in the Eurozone that are feeding a real estate bubble in Germany (and Sweden too) are still higher than in the US, UK or Japan.

In any case, Draghi is convinced that it's all been worth it. He's also convinced that it's now time to stop. "We have done enough," he told the FAZ, adding that, in future, the focus would be on "tightening the requirements again." 

But there are many bankers who suspect that he won't find it that easy to slip out of the role of Europe's bankroller. Indeed, it will be difficult to wean the banks off cheap and generous loans from the ECB.

In fact, a number of banks would again find themselves in trouble if that happened, because investors are even more loath to lend them money after years of dependency on the ECB. 

In many regions, the economy would simply run out of money -- as is the case in Greece.
For TT Hellenic Postbank chairman Kleanthis Papadopoulos, the situation in his country is clear. "Greek banks are dependent on the ECB for their funding," he says.

As I have said since the beginning of the financial crisis, there is only one way to exit all of the central bank  funding programs and government bailouts and that is to provide ultra transparency.

With ultra transparency comes adoption of a Swedish model for handling a bank solvency based financial crisis, because, even if the regulators do not require the banks to recognize the losses on and off their balance sheets, the market will.