Liquidity Crisis in Europe
There is a growing risk of a liquidity crisis in the German banking system. The German banks are expected to have enormous debt defaults this year as corporate bankruptcies increase again to another record. Last year 38,000 corporate bankruptcies occurred in Germany. This year that number is expected to rise to 42,000.
This presents two problems:
First, there is a growing expectation that if the German and overall European economies continue to slow, as is most probable, it could force a government sponsored bail out of the banking system. In other words the German government would have to first absorb the bad loans from the banks and second figure out how to infuse new capital into the banks.
Second, if a crisis of confidence develops and depositors, worried about the security of their deposits, begin to remove money from the banks a bank run could develop.
What we are going to focus on here is what could cause a bank run and what would probably occur in the capital markets as a result.
When the European Central Bank was founded many restrictions were placed on it by the individual member countries as to how the ECB would be allowed to manage monetary policy. Additionally there were restrictions placed on the individual member countries by the ECB mandate as to how they could manage their internal fiscal policy.
These restrictions will play a roll in what we will discuss and I will be back to them in a minute.
Finally, and the key to our discussion here, which makes the prospects for a bank run very real, is a specific piece of regulation that was left out of the ECB agreement.
The regulation was a mandate covering insurance protection for bank deposits. This is not a new topic and has been debated frequently over the past 10 years.
At the behest of the German government there was no collective insurance policy put in place to cover all of the banks operating within countries that otherwise were covered by the ECB agreement.
Instead there was a directive passed in December of 1997 that mandated that each individual country develop its own insurance scheme. gib.gi
This was forced upon the ECB at the request of Germany because the German government did not want German money being used to bail out Italian banks. At the time the German banks were considered to be very strong and the Italian banks were experiencing problems.
The problem today is that the German banks are facing a liquidity crisis and the individual country insurance policies are not considered to be capable of providing the liquidity necessary should the bank default rates this year increase above projections.
In other words, if the European economy and specifically Germany continues to slow, as is expected, the prospects for a systemic break down increase.
Compounding this is the fact that the regulatory restrictions placed on the ECB with respect to its monetary management restrict it from lowering interest rates and increasing money supply in a preemptive attempt to reduce the rate of contraction and debt defaults.
Also, the restrictions placed on the fiscal management of each country restrict their ability to issue sovereign debt to add the necessary liquidity in the event of a crisis. What is even worse is that by ECB agreement the individual countries can not exceed sovereign debt issuance by more than 3% of GDP. If GDP is falling the governments are actually then required to reduce the growth of sovereign debt issuance precisely when it is most needed.
Which takes us back to the ECB's ability to stimulate through rate reductions and money supply. The ECB itself can not do so unless GDP growth rates fall below 2%. The problem with that is that it is reactive. If there is a liquidity crisis it won't be measured in economic terms until after it has already occurred.
This is like having a car with air bags that deploy AFTER the crash has already occurred rather than while it is occurring.
By the time the ECB's mandate allows it to address a liquidity crisis the banks would already have been closed.
Now, of course this will not be allowed to happen. Some sort of change allowing for fiscal and monetary stimulus would have to occur.
The problem for investors, depositors and the capital markets overall is that whatever that is has not yet been determined.
It's like discovering your breaks have failed while driving down the road and not being able to pull over to fix them. Instead they must be fixed while the car is still moving.
This, once discovered by the capital markets is going to exaggerate the concerns over a potential liquidity crisis and could actually cause the crisis as depositors preemptively move to get their money out of the banks ahead of the increasing probability of the crisis occurring as they watch the bank defaults increase this year.
This is exactly what occurred in the US in the 1930's. A crisis of confidence and no FDIC insurance bankrupted many individual banks and their depositors.
Now, in the early phases of a flight to safety, which is already occurring and which would occur prior to a bank run, capital flees first out of paper assets, like stocks and bonds, and into the banks and the sovereign debt of the country. In other words, ironically the first thing that occurs is that money moves to a place it perceives to be safe; but in reality may not be.
This affords investors that have done this ahead of others to get an appreciation on the sovereign debt and the perception of safety in banks.
But, if the bank defaults increase at a faster rate than deposits move into the banks and the banks begin to require government assistance a collective realization of real bank deposit risk may sweep the country.
When this occurs it is called a crisis of confidence and can lead to panic and that to a bank run.
The crisis and panic are not born out of real issues but perceived issues. The lack of a predetermined monetary and fiscal policy for handling a liquidity crisis is what causes the liquidity crisis. It is like an economic vertigo.
What would happen
The most recent events that we can draw a correlation to would be the events of 1997. That year Russia defaulted on its sovereign debt which became the impetus for a panic flight to safety out of all capital markets, including sovereign debt world wide, with the exception of US Treasuries.
This migration out of everything else and into US Treasuries is what then caused the collapse of Long Term Capital Management, the largest hedge fund in the world at the time, when it posted paper losses of over 1 trillion dollars.
LTCM's investment structure was based on a quantitative model called Black-Scholes. As we discussed LTCM and Black-Scholes in depth in the past I will not review here.
But, the important thing to note about the Black-Scholes model is that one of its fundamental tenets was that as US Treasury yields fall, so do the yields on all other large economy sovereign debts.
Yields on US treasuries have fallen dramatically this year and in response so have the yields on most foreign sovereign bonds. As this occurred while at he same time the dollar depreciated against the Euro returns on sovereign, primarily German debt have been spectacular over the past 12 months.
As the European economy is projected to continue to slow and the dollar to depreciate many are maintaining that buying German bonds is a safe alternative to other investments. And it is, unless there is a liquidity crisis.
Think of it like a rubber band. As it stretches it gets bigger, just as the return on sovereign foreign debts increases due to the causes listed above. But, if you keep stretching that rubber band it will eventually break.
We are not near that occurring yet but the prospects for it are increasing and I want you to be aware of it especially if you are buying foreign bonds.
You must watch this situation very closely. I will be watching it as well.
Roger Arnold --- Mortgage Applications at www.MyHomeLender.com |
