When the case of Europe is scrutinised there is both good news and bad news. The good news that one can understand for Europe is the fact that a dramatic Lehman style collapse is not quite on the cards. The European Central Bank has been doing sufficiently well to ensure that there is enough liquidity despite the crisis situation. The bad news is that while conferences and summits are being held to find a solution to the debt crisis, Europe’s leaders have failed to realise that old banking systems in this fast globalising world have now become obsolete. Coupled with this, there is an over reliance on leveraging from the private sector for balance sheet woes of both sovereigns and banks. This policy is eventually destined for doom. One cannot fathom why authorities have found it so hard to agree on the cause and effect of the crisis. They have however identified four problems which are, sovereign debt, bank capital, Greek default and growth retardation.
When analysed in greater detail, in general the EU has outsized banks (assets almost equivalent to 325pc of GDP) which are highly leveraged (it is pertinent to mention that leverage of the 15 largest banks of Europe is 28.9 times their equity capital). These institutions are also addicted to large quantities of wholesale debt, which totals euro 4.9 trillion out of which $660 billion matures in the next two years. According to a report, the largest banks of the zone have phenomenally increased their returns on equity, between the late 90’s till 2007 with almost 90 per cent of the gain coming from high leverage. Since 2007, the returns have crumbled.
The viability of this model is highly dependant upon high amounts of cheap leverage that have some sort of implicit backing by the government. Declining confidence in sovereign debt has deeply dented bank borrowing by increasing the cost of capital. In times of recession, government borrowing costs fall. However, what is interesting to note is that with ‘risk free’ rates rising almost six fold in the past few years, cost of equity and simultaneously debt has surged manifold as well.
With economic growth slowing down to much lower levels than anticipated, higher levels of capital will now be required, in other words capital buffers will have to be built. Restoring investor confidence through recapitalisation is not an answer, because the real problem is growth. With the exacerbating sovereign debt equality, there is a need for banks in the euro zone to have higher capital-adequacy ratios in order to compensate for higher risks. In modern emerging markets this is a reason why banks keep higher capital buffers. Just like credit cycles in those markets tend to be more frequent, with an imminent currency crisis, largely due to high sovereign debt costs and relatively slow adjustments to shocks suffered as a result of exchange rate, balance sheets have become a burden to support and thus have been rendered obsolete.
Risk weighted assets of French banks are estimated at euro 2.2 trillion against a real capital base of euro 167 billion. However what is more striking is that once the risk weights are removed, assets inflate to a mammoth euro 8.1 trillion which is estimated at approximately 400 per cent of GDP with equity – asset ratio falling to below two per cent. The gods have spoken and the sovereign ground is now shaking vehemently. In such times building several more concrete floors over a skyscraper of leverage will not be enough to convince wary tenants to come back. If confidence in sovereign debt is not restored within the EU – which seems unlikely – these banking skyscrapers are no longer sustainable and instead of adding more concrete floors will have to be broken. The bubble will now have to burst, since it is now sufficiently clear that no amount of capital can restore investor confidence in EU banks.
The solution of the European quagmire can either be a broad and wide debt restructuring which with its course of natural selection will wreak losses on the private sector or an ever greater bailout package by burdened tax payers. Europe is in dire straits, whether commentators like it or not, whether they agree with it or not. The only real solution now lies in allowing a Greek default, in letting the market deflate, in letting the bubble burst. The French and the Germans, no matter how much they gripe about at conferences trying to find a solution, cannot revive the dead. No, they do not have that super human ability, and the present circumstances are certainly such, that as long as they keep delaying the inevitable they would be pulled into the quick sands of oblivion.
The writer is a seasoned banker with over 30 years of experience and is currently working as Chief Manager SME bank
