The question of course is how to stop the bank runs.
To date, the solutions provided by policymakers have reflected the Japanese model for handling a bank solvency led financial crisis. They are focused on restoring confidence without disclosing the true condition of the banks -- think bank stress tests and firewalls.
Regular readers know this will not work. The source of confidence in banks and financial markets comes from market participants having access to all the useful, relevant information in an appropriate, timely manner so the market participants can independently assess risk.
Confidence flows because market participants trust their own independent assessment.
The euro area’s financial troubles appear to be flaring up again, as this week’s gyrations in the Spanish bond market show. In reality, they never went away. And judging from the flood of money moving across borders in the region, Europeans are increasingly losing faith that the currency union will hold together at all.
In recent months, even as markets seemed calm, sophisticated investors and regular depositors alike have been pulling euros out of struggling countries and depositing them in the banks of countries deemed relatively safe. Such moves indicate increasing concern that a financially strapped country might dump the euro and leave depositors holding devalued drachma, lira or pesetas.
The flows are tough to quantify, but they can be estimated by parsing the balance sheets of euro-area central banks. When money moves from one country to another, the central bank of the receiving sovereign must lend an offsetting amount to its counterpart in the source country -- a mechanism that keeps the currency union’s accounts in balance. The Bank of Spain, for example, ends up owing theBundesbank when Spanish depositors move their euros to German banks.
By looking at the changes in such cross-border claims, we can figure out how much money is leaving which euro nation and where it’s going.
This analysis suggests that capital flight is happening on a scale unprecedented in the euro era -- mainly from Spain and Italy to Germany, the Netherlands and Luxembourg (see chart).
In March alone, about 65 billion euros left Spain for other euro- zone countries. In the seven months through February, the relevant debts of the central banks of Spain and Italy increased by 155 billion euros and 180 billion euros, respectively. Over the same period, the central banks of Germany, the Netherlands and Luxembourg saw their corresponding credits to other euro- area central banks grow by about 360 billion euros.
The seven-month increase is about double the previous 17- month rise, and brings the three safe-haven countries’ combined loans to other central banks to 789 billion euros, their highest point on record. In essence, the central banks of the three countries -- and, by proxy, their taxpayers -- have agreed to make good on about 789 billion euros that were once the responsibility of Italy, Spain, Greece and others.
The worries about Italy and Spain reflect the inadequacy of Europe’s efforts to stem what has become a combined banking, sovereign debt and economic crisis.All of this is a direct result of selecting the Japanese model for handling a bank solvency led financial crisis.
By protecting bank book capital levels and allowing the banks to hide losses on and off their balance sheets, European policymakers have transferred the losses on the excesses in the financial system to the real economy.
The European Central Bank’s efforts to prop up bond markets with more than 1 trillion euros in emergency bank loans have only encouraged Italian and Spanish banks to buy more of their governments’ bonds, tying their fates to those of the afflicted sovereigns.
The harsh austerity measures required by Europe’s new fiscal compact are making things worse by stunting the economic growth needed to help the countries reduce their debt burdens.
Should markets balk at lending to Italy and Spain, Europe’s bailout fund -- with only about 600 billion euros in spare capacity -- remains far too small to cover the two countries’ financing needs, which amount to more than 1 trillion euros over the next five years.
If Europe’s leaders want to stop the rot, they’ll have to change their approach.And adopt the Swedish model for handling a bank solvency led financial crisis including requiring banks to provide ultra transparency and disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.
It is these details that let market participants independently assess the risk of each bank and restore confidence.