Europe’s political and economic class holds a mistaken belief that financial crises in the US have little to do with them. However, they are repeatedly proven wrong. Despite the triple challenge of deposit outflow, reduced commercial property value, and losses on US debt securities by regional banks in the US, the Eurozone banks have not yet been affected by the contagion. EU policy circles are lauding their stricter regulations for keeping the problem at bay.
One can only be grateful that something hasn’t gone wrong yet. However, there is a high likelihood that a banking crisis will occur due to the rapid decrease in the money supply. Additionally, the eurozone currently doesn’t have the necessary measures in place to deal with such a crisis. Unlike the US Treasury, Federal Reserve, and Federal Deposit Insurance Corporation, who can act together to implement rescue measures, the EU authorities lack the legal authority to do so.
This is not to say that Washington has made a good fist of it
The policy of the US, which requires troubled banks to be taken over with the condition that shareholders and bondholders should incur losses, has unintentionally led to a worsening of the situation. As a result, struggling banks now face greater difficulty in acquiring funds or finding potential buyers.
Could you clarify who is legally tasked with rescuing a bank in the eurozone? I understand that the Bank Recovery and Resolution Directive (BRRD) does not permit governments to bailout uninsured depositors during a crisis and that there is no similar clause to the US “systemic risk exemption” which helped limit contagion during the Silicon Valley Bank collapse. However, I find the BRRD confusing.
The intention of the measure is to prevent taxpayers from bailing out banks in the future. However, its implementation could cause chaos as it imposes severe and conflicting conditions. This could lead many European banks to fail the “bail in” requirement, resulting in the seizure of savings from ordinary depositors (as occurred in Cyprus). Furthermore, the eurozone banking union remains incomplete, as there is still no shared deposit insurance for banks, and the infamous “doom loop” from the 2011-2012 financial crisis persists.
Even though a country in the eurozone cannot print its own money, set its own interest rates, or have its own lender-of-last-resort anymore, it is still responsible for rescuing its own banks. Additionally, it has no means of stopping risky inflows of speculative capital like what happened to Spain. This means that a banking crisis could still potentially drag any of the high-debt eurozone countries down with it.
The main issue is that countries like Germany and the Netherlands, along with other creditor nations in the Northern region, are hesitant to agree to a fiscal union and issuing joint debt on a permanent basis. They have a valid reason for this concern – it would greatly diminish their own parliaments’ power to govern tax and expenditures. Additionally, they don’t want to share their credit with countries in the South that haven’t reformed their high debt practices. Unfortunately, this means that the bloc is susceptible to a “spread” crisis whenever difficulties arise.
The European Central Bank’s Dilemma: Balancing Inflation and Economic Slowdown Amidst Tightening Credit Standards
The European Central Bank is facing a difficult situation, which is partially caused by their own actions. Although core inflation has been increasing over the past few months and is currently at 5.6%, the economy of the Eurozone has slowed down and is almost in a state of recession. Additionally, there is a reduction in bank lending.
According to the ECB’s bank lending survey, banks have been tightening credit standards at a rapid pace – the quickest since the eurozone debt crisis. This could have significant effects on the economy, as bank lending currently accounts for 93% of total credit. As a result, the risk of a severe credit crunch is becoming increasingly likely. The governing council believes that inflation is the more pressing concern at the moment.
On Thursday, the central bank raised interest rates by a quarter point and indicated that two more increases were forthcoming. In addition, it announced that it would be doubling the pace of quantitative tightening, which hastens the decline in broad M3 money. This decision is likely to harm weaker banks in Italy and Spain, with no measures in place to alleviate the impact. There are €1.2 billion of cheap emergency loans (TLTROs) to be repaid in tranches, with €470 billion due to the ECB next month.
Krishna Guha from Evercore ISI commented that the decision was unwise in light of the global banking stress. The Bank of Italy’s financial stability report cautioned last week that almost half of the Italian banks lack sufficient reserves to repay the TLTROs in the upcoming quarters.
Monetary Policy Tightening Amidst Lingering Bond Market Losses
If they look for funding elsewhere, they will have to borrow money at higher costs, which will reduce their operating margins. In the next few months, we will see whether this current monetary policy tightening is a mistake like the ECB’s excessive policies during the global financial crisis in 2008 and the Italian and Spanish bond market collapse in 2011.
The banks in Europe are dealing with a similar issue as the banks in the US, but the timing is different due to the lag in the start of the tightening cycle. European banks are also carrying significant losses from their bond portfolios, which they acquired during a period of negative interest rates when most European sovereign bonds had negative yields.
The European Banking Authority is investigating the “interest rate risk,” but no information about the magnitude of the losses has been released yet. Compared to US banks, Eurozone banks are at a greater risk due to the decreasing value of commercial property, as a smaller portion of the risk is transferred to others through mortgage security packages.
In addition, these banks provide funds for home mortgages directly and hold €4.1 trillion of these mortgages as assets. However, the income they generate from old mortgages is significantly less compared to the interest they have to pay to attract deposits. The similarity between banks in both the US and Europe is that they have suffered from regulatory and central banking negligence towards the financial system.
The speaker believes central banks have actually caused financial instability instead of preventing it. They compare this to the story of a sorcerer’s apprentice who creates chaos through their inability to control their magic.
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