A new euro zone crisis in the making? The Bank of Italy's omen on stress testing

Today, the Bank of Italy proposed a bad bank for non-performing loans for the banks it supervises. The government is denying that there is a need for such a bank, that would have to have state guarantees for the loans the bank holds.

On November 4th of this year, the ECB is supposed to take over supervision for the EU's 128 largest banks. Before that happens, the ECB will undertake stress tests and identify amongst other things, non-performing loans that need to be cleaned up.

If the Bank of Italy's proposals were taken on board by the government, it would be a sign of economic responsibility in Italy to cleaning up its banking sector, but the political mentality appears to be twofold in Italy--that the state couldn't pay if it wanted to, and therefore that what you don't know won't kill you. But it will, and that will unleash a new crisis in the euro zone as the markets guess the level of the damage.

The Single Supervisor Mechanism is not a Banking Union

The EU member states have just reached a deal to grant the ECB oversight of roughly 200 EU banks. That is a small fraction of the roughly 6000 that would have been supervised under the original plan that the Commission proposed.

The most important features are still to be determined, but the ECB has stated clearly that it would require extensive powers to make the project work. For the goal, as far as the ECB is concerned was to establish some type of banking union that would mean forced mergers and takeovers, the power to take away ownership rights from shareholders (some of who are member states themselves), engage in other forms of strenuous intervention, and be responsible for all banks, getting beyond the myth that only large institutions can cause systemic failure.

The agreement in principle this morning is not yet a banking union. There will be further international negotiations that appear fated to water down the powers even further than they have been already, and the legal challenges have already been flagged.

Terror, Greece, and European Collapse

Over the last week, it has become apparent that the Greek tragedy could soon become a European one. If that happens, there is a significant risk of financial collapse in Europe. The good news is that policy makers are trying to avoid it. They may succeed. But it is possible they will fail. If they do, then a cascade of bank failures will reach to the heart of the EU's financial centres. Banks that are not yet under public ownership could find themselves under government stewardship. The threat of that might be the only thing to prevent all of this from happening.

First things first. The European Central Bank has been arguing vehemently for some time now that a default of Greek debt, a partial default, a restructuring, a partial restructuring, call it what you will was completely and totally unacceptable. This has had a number of people scratching their heads.

At first, the ECB offered the explanation that defaults, even partial ones, would result in a lot of credit default swaps becoming payable. That could cause some banks to go bankrupt. A credit default swap is effectively an insurance policy that one bank sells to another in case someone fails to pay a loan back to them. In theory, the swap is a good way of insuring a bank against a loan going bad. It's supposed to be good for stability. In fact, one of the recognized principles of good banking is that banks should use them. And they use a lot. The last I looked, there were more than $62 trillion in credit default swaps out there.  So the ECB is telling us that one of the key tools that was supposed to prevent a massive collapse of the financial system is precisely the thing that could bring it about.

This is not only a point that Europeans should be concerned about. It's one that everyone should worry about, for it continues to be one of the supporting pillars of financial stability on a global scale. I will return to this in another post. The important part here is that even if everything else were in good shape, the ECB is telling us that the safety features that will save our lives should there be a crash will not and cannot work. It illuminates the fact that credit default swaps are really intended to work when only one debtor fails to pay. If several fail to pay, then you suddenly have a problem again. Effectively the swaps simply transfer risk from one bank to another. Someone still has to pay, and then that bank goes under in the second round. Unless the original bank invested in that bank and goes under in the third round, and so on. On top of the losses caused by swaps that undermine the banks who sold them, there will be direct losses for banks that held the loans without the swaps. Bottom line: a lot of money will disappear off bank balance sheets, and the ECB, the Bank of England and so on will be back to the choice of saving banks or not. As will national governments who will have to consider nationalizing more banks. For they have no more money to pump into them.

But there is more. Because the ECB has been buying Greek and Portuguese bonds, a default, even a partial one, will destroy part of the central bank's capital. This is one of the reasons why the ECB isn't technically supposed to buy these bonds from them. The ECB, like any other bank, needs to have assets on its books against which it issues currency into the system. If those assets drain away in significant numbers, you have a problem. You can accept a big dip in the money supply and the economy, or you radically expand the ratio of currency to real output. That means you either print money outright, which the ECB can't do legally, or you provide it for every piece of toxic waste financial paper that a bank waves your way, which is unwise but legal, and what the ECB did during the earliest days of the financial crisis.

All this would mean low interest rates (or at least an end to higher interest rates) at a time when global inflation is running relatively high. That would mean a radically devalued euro, if it continues to exist at all. The alternative is a new, radical wave of nationalizations coupled with an extended economic crash, the likes of which Europe hasn't seen since the 1930s or the 1870s.

That's why there has been so much pressure on the banks to hold onto Greek and Portuguese debt, to not ask for their money back. Technically, that wouldn't be a default, so bank balance sheets will stay clean, swaps will not be paid out, and the problem will 'go away'. For a while.  If they don't, Greece will be bankrupt by October at the latest, and we will see how quickly the contagion spreads to the heart of Europe. That can happen overnight.

The prospect of going bankrupt themselves and being nationalized is the only incentive the banks have left to play along. Roughly 65% of the banks were on board as of today, according to press reports this morning. There will need to be more if the plans are to work.

Terror has a new meaning in the second decade of the 21st century. For 50 years after WWII, it meant the threat of global nuclear holocaust. After 2001, it turned into the threat of terrorist attacks on a smaller scale.

We're back to the threat of global meltdown again. And the epicenter is Greece.

Germany blocks the ECB

Jean-Claude Trichet, the President of the ECB, has a term of office that extends into October and cannot be renewed under the existing rules. And yet, Europe cannot agree on a replacement.

Let me rephrase that. Germany cannot bring itself to support the candidate that everyone else seems to have agreed on. This is despite the fact that the Chancellor herself has praised the candidate, his policies and his credentials. Mario Draghi is the current Chair of the Financial Stability Board, the global body responsible for ensuring that there will not be another financial crisis. In terms of policy, Draghi brings everything to the table the Germans want. He is clear on the question of whether the ECB should continue to purchase bonds from bankrupt eurozone governments as Trichet has reluctantly done. He says the ECB wouldn't do that on his watch. He would be tough on inflation. What more can Germany want?

That is the question. Germany seems to want to teach Europe a lesson. Not just the 'deficit sinners' who will be cast into the fire, but France and Italy as well. The level of hysteria in the German press and in German politics against foreigners is breathtaking. They're not only mad at the so-called PIIGS, they're mad at the ECB as well. And that is run by a Frenchman.  Chancellor Merkel wanted a German candidate, Bundesbank President Axel Weber, to be the next head of the ECB. He withdrew from the running after citing opposition from Europe and from within the Bank itself to his intent to run a tight ship. And it seems in her eyes, the German chanting for European blood could only be appeased by a Teutonic captain at the helm of the ECB.

There is a saying coined by Carl Jung that what you resist persists. In the context of German hysteria, the Weber Affair blew up because it had to. Weber came across outside Germany as arrogant and contemptful of his European colleagues, echoing what Europe hates about Germany most. Only 10 years ago, Germany was an economic basket case. It flouted the rules that it demanded be applied to others. It defied the application of economic penalties in the mid-2000s when it passed one emergency budget after another. Now that it is back on track, it is screaming for obedience and punishment according to terms it would never accept for itself. 

Germany has been rightly criticised for a lack of sensibility in how it deals with its European neighbours. One might argue that there is little the German government could do in the face of such domestic revulsion for Europe. Except for one thing. Merkel forgets that Germany has been here before and chose European cooperation rather than an all-out War of the Roses. In 1991, Merkel's mentor, Chancellor Helmut Kohl, conceded minor points to the hysterical politicians who wanted to torpedo EMU. But he insisted that you had to compromise in Europe, that Germany actually had to get on with its neighbours. Germany's past, he argued, demanded that. 

Germany is at the verge of destroying Europe. It may not in the end, but it is making it weaker every day.

The Noose Tightens on Southern Europe

We've been waiting a long time to see when interest rates would rise in Europe. The ECB has been giving signals for the last month that it will raise them at its next board meeting in early April.

The ECB is concerned about inflation, so rates will rise. That means the euro zone's countries with deficit problems are about to see them get worse.

The Rise of General Trichet

The writing is on the wall for Europe's political leaders this week, and so far they have done nothing. The consequence of this is that the ECB is taking over areas of policy out of necessity.

It is not as if the warnings have not been made. One after the other this week and last, the key economists who played a role in establishing the euro have warned that the Stability Facility is woefully inadequate and in need of support. Willem Buiter warned last Friday that the war to defend the euro was running out of ammunition because the Facility was too small. Today, on Wednesday, European Commission President Manuel Barroso, made the plea for member state governments to funnel more resources into the fund. Ottmar Issing underlined yesterday, in contrast, that no solution would ever be sufficient unless euro zone member states addressed the need to impose budget discipline on all of its members. Meanwhile, Jean-Claude Trichet, President of the ECB, confirms that the European Central Bank will continue to purchase government bonds for the foreseeable future from countries that cannot place them on the market to avert even greater catastrophe. 

In the meantime, Germany is denying that it needs to do anything, bondholders are denying they will have to take a haircut, Portugal is pretending that markets have confidence in its bonds, and Greece is pretending it will not default on its debt this year. This is reckless denial on a catastrophic scale. Economists may not always be right, they may not agree, and they are rarely popular, but in this case, Europe's political leaders would do well to listen to the list of choices they have at their disposal. 

An ominous warning in Buiter's statement to the press was that if the governments of the euro zone could not sufficiently fund the Facility, the ammunition to fight the war would have to come from elsewhere. For unless the euro zone admits defeat and ejects its weakest member states, or admits that they are bankrupt, someone will have to fight the war that the politicians haven't been willing to wage on their own behalfs.

Enter Trichet. Under his leadership, the ECB is purchasing government bonds from the euro zone's weakest member states. The Bank is far from happy about doing this, but sees no alternative for the time being. As the politicians fight one another and refuse to face the enemy, it is up to the bank to save Europe.

Trichet's position today resonates with the historical development of his own country of origin. The French Fifth Republic was the creation of General De Gaulle, a necessity for a country that lay in political shambles in the 1950s and could not govern itself. It required strong, centralised political authority that ordinary politicians were incapable of providing. That was not so much a statement of De Gaulle's authoritarian character as of France's polarised, fragmented political class that was allowing the country to collapse without his intervention.

Trichet's position is not the same as De Gaulle's, but his potential importance is at least as great, and arguably, immensely greater. In a world where the greatest challenges to public welfare are economic, and where decisions have to be made to harden and mobilise the country to keep it strong, the ECB is the only institution with the overview and the means to act where politicians have failed. And Trichet is the General.


There has been some speculation about what will happen when Trichet's existing term of office ends in late 2011. His term cannot be renewed under the terms of EU law. There await blistering divisions within Europe about what candidate should replace him. Nothing less will be at stake than what kind of single currency survives 2012.

But. The member states of the EU are busy negotiating changes to the Treaties to allow the Stability Facility to be funded. They could, and should amend it as well to allow Trichet's reappointment if he were prepared to serve on, at least until the crisis is over and calmer political temperaments prevail. In a highly polarised environment, that is probably the best thing that could happen to Europe.