As the Brexit worries began two weeks ago, I flagged Italian banks – more than the UK economy – as one of my principle concerns, because of the potential to cause systemic damage to the euro system. And now the contagion is spreading, with Deutsche Bank the most obvious weak link. The question now is twofold. First, does the Italian banking crisis solve itself without a major overhaul of EU institutional arrangements? Second, if not, how does the EU solve this problem? Some brief thoughts below.
About a year ago, as the Greek crisis was hot and heavy, I wrote a post on why the euro is a failure. And in that post, I used the Italian economy and Italian banks as the most obvious economic example. The reasoning here was that Greece was only a more extreme example of what could befall other weak European economies in a generalized economic downturn. The Troika had submitted Greece to the rack under the pretense that it was a separate case. My argument was that it was not a separate case, just a more extreme case – and potentially the first case of economic collapse due to the failure of the eurozone’s institutional setup.
My view then – and today – is that Italy matters to the eurozone and the EU almost as much as France and Germany, given its role as a founding member of the European Coal and Steel Community in 1951 and the European Economic Community in 1957. If Italy were forced into a desperate situation, it could be fatal for the euro. And now, a year later, this nightmare scenario is coming to pass – or at least we are getting a glimpse of it. We don’t know if this is a real crisis or a mini-crisis yet.
What we do know is that the Italian banks are both under attack from investors and simultaneously undercapitalized. We know this because Italian bank shares have fallen by more than half this year. And we also know that the Italian Prime Minister Matteo Renzi has floated the idea of injecting 40 billion euros of state-sponsored capital into the Italian banks. Meanwhile, the ECB has made liquidity available to the Italian banks – if they need it – under the proviso that solvent institutions may just be going through a liquidity crisis. But, as we saw in the US, with TARP, eventually more state capital was needed.
Now, let’s remember the constraints here. During the sovereign debt crisis, banks and sovereign credits became co-mingled because banks owned lots of sovereign debt. And so as sovereign debt soured, so too did the condition of euro banks. This eventually required a bailout of Spanish banks via the state, making clear that – given the lack of a common bank resolution mechanism – the contingent liabilities of banking systems fell to the state. The other major eurozone bubble economy, Ireland, suffered a similar fate after the sovereign was forced to bail out its banking system, mandating a Troika bailout for the state in turn. This is a situation that no one wanted repeated. In fact, if bail-ins – like the one in Cyprus that Willem Buiter warned us would become the model – were in effect, Ireland never would have needed a bailout. As people like myself suggested at the time, banks would simply have defaulted.
We have known for some time that most European banks are zombies, unable to increase lending because of a lack of capital. Buiter said so explicitly in 2013 during the Cyprus bail-in. And the lack of growth in Italy has made this problem far, far worse. Look at this chart from Holger Zchaepitz showing the connection with causality from bank lending to the economy – and realize that Italy has not grown since joining the eurozone, souring loans and making the capital situation worse.
— Holger Zschaepitz (@Schuldensuehner)
But now we see the problem in Germany too, with Deutsche Bank. Everyone is talking about it because the shares have been cut in half and the contingent convertible debt carries a yield of 11% while Deutsche Bank CDS is higher now than it was at any point during the 2008 crisis or almost any time except briefly during the sovereign debt crisis. Markets are basically saying Deutsche Bank is a junk-rated company given its present capital situation – and given the post-Brexit referendum fall in shares taking away the ability tor raise more private capital.
And so what happens in Italy is inextricably linked to what happens in Germany. Is Germany concerned about its own public finances? Absolutely – that’s the reason for the change in its constitution to limit deficits and it’s the reason for the schwarze Null – no new debt – that Schaueble is constantly after. The fact that Germany had been in breach of the Maastricht Treaty was a point of shame for the country. And now the German finance minister wants to rectify the situation with no new debts.
So we know categorically that the German finance ministry will fight tooth and nail to not bail Deutsche Bank out – and to stick to the bail-in rules already instituted.And clearly if Deutsche Bank were subject to a bail-in, then the Italian banks would have to be too.
I think this is a big problem for Europe. There is no way out of this mess given the German stance on public debt and the pre-existing rule against state financing of banks. I don’t see the EU relaxing these rules, despite calls by Deutsche Chief Economist David Folkerts-Landau (link in German) – my boss at Deutsche some 15 years ago – and by SocGen chairman Lorenzo Bini-Smaghi. TARP is not the way the EU is supposed to work. And without a common banking resolution mechanism, the fallout of bank crises falls on state actors that are forbidden from receiving financing via the ECB. Bail-ins are the only way around this problem.
If the situation in European banks doesn’t calm down, we could be on the verge of a serious banking crisis. And that means panic, bank runs, and a meltdown in shares and the real economy. This is definitely the tail risk here. Europe should take the bull by the horns and take this tail risk off the table now – and for good. I don’t think Europe will though.
As usual, I see Anglo-Saxon government bonds as the ultimate safe haven in such an environment – as all rates converge to zero (or lower).