Financial Crisis 2.0

As governments in the eurozone sink and banks move towards collapse, the nightmare of 2008 is back to haunt the world.

HELD hostage by finance, the developed world seems to be hurtling towards another financial crisis. Banks in Europe are increasingly shaky. Dexia, the Franco-Belgian bank, has gone near-bankrupt, forcing the Belgian government to take over the bank's Belgian operations and the French to organise a forced merger of its French operations, signalling a partial return to the temporary nationalisation experiment that enriched banks after the previous crisis.

Meanwhile, eurozone governments and the European Central Bank (ECB) are desperately seeking funds to recapitalise banks that are likely to collapse under the combined weight of sovereign default or sovereign debt restructuring and default of debt to a recession-hit private sector. Just as the fallout for Europe was immediate, when American finance was under siege, the reverse is also likely and is already showing signs of occurring. Another financial crisis at a time when the world has lost the will to deal with the consequences of the first one is bound to be disastrous.

Yet there is no solution in sight. Consider Greece for example, where the exposure of French and German banks to public and private debt amounts to $52.9 billion and $35.7 billion respectively out of European banks' total exposure of $142.5 billion at the end of the first quarter of 2011. A cash-strapped Greek government and a collapsing Greek economy is not good news for the banks concerned and, therefore, for the countries where they originate.

When representatives of the European troika the European Commission, the ECB and the International Monetary Fund (IMF) visited Greece in mid-October to examine the country's performance relative to tough austerity measures, all it could promise was that the next tranche of assistance would be released in November, subject to Greece redoubling its efforts to realise missed fiscal targets. What was ignored was that the tranche was too small to save Greece from default. What was missed was that the austerity made it impossible for Greece to even reduce its debt.

FEAR OF CONTAGION

This is not to say that governments are not worried. With clear signs that bond markets are turning the screws on Italy, and are likely to hold back on lending to its government, and that rating agencies are contemplating protecting themselves by downgrading even French debt, the fear of contagion that could affect the core of the eurozone is growing. When debt gets downgraded, not just governments but also banks are forced to obtain funding at a higher interest cost. They also find it difficult to get such funding even at the higher cost. Investors fearing default on the credit given by banks to the public and private sectors want more security than the risk premium offered.

Earlier, banks partly overcame this problem by buying credit default swaps (CDS) to hedge against a possible default. With risk hedged in this manner, banks' books look less shaky to funders. But buying CDS is also proving too expensive. According to Financial Times (October 9), the iTraxx index, which measures the cost of buying insurance against a bond default, has risen by 257 basis points since August 1, touching levels higher than those that prevailed after the Lehman collapse. With CDS turning expensive, banks are not able to use that route to persuade funders to give them money, forcing them to rely on collateral that is limited. In the event, their ability to avoid liquidity problems despite carrying higher funding costs is under challenge.

Moreover, higher CDS costs imply that banks should be writing off some of their assets. The IMF's Global Financial Stability Report team used CDS prices to estimate the market value of government bonds issued by Ireland, Greece and Portugal, besides Italy, Spain and Belgium. That exercise showed that if these bonds were marked to market (or priced at their implicit market value) the base capital of European banks (their tangible common equity) would fall by about 200 billion or around 10-12 per cent. Stated otherwise, to remain solvent banks have to find a lot more new equity.

The higher interest cost is also leading to shrinking profit forecasts for even leading European Banks such as Deutsche Bank. Besides higher costs, the need to write down debt owed by governments such as that of Greece is affecting profit and loss accounts, leading to a flight out of banks' stocks in Europe. Banks have taken a big hit in stock markets in recent weeks. What is more, the banks themselves have parked a growing volume of their funds with the ECB as they fear lending to other banks. The fear of counterparty risk that froze financial markets in 2008 seems to be back.

GOVERNMENTS CAVE IN

As a result of all this, eurozone governments that dismissed calls for a recapitalisation of their banks, including from IMF's Managing Director Christine Lagarde, have caved in. Recapitalising banks, ensuring easy liquidity conditions and perhaps reducing interest rates have become the central concern of European governments and the ECB. But that requires more than just liquidity or even government guarantees of doubtful debt, as the Dexia case illustrates. What seems to be the concern of leading eurozone governments is finding money to achieve three separate goals. One is to keep afloat the peripheral eurozone countries trapped in crisis so that the eurozone itself does not break up. The second is to find money to fence in countries such as Italy that are now also under threat from bond markets despite the adoption of austerity measures. The third is to recapitalise the banks, besides ensuring that failure on the first two counts does not make their funding requirements impossible to achieve.

To meet these demands, the eurozone is attempting to strengthen and make effective the 440 billion European Financial Stability Facility (EFSF) in the hope that it will serve as a future European Monetary Fund. But that requires agreement, and as experience proves, even a small country like Slovakia can put a spoke in the wheel. While the EFSF enhancement may go through anyway, it shows that the challenges to resolving the crisis are more than economic. That challenge comes not just from small Slovakia. It comes in one form or the other from every European government, since all of them seem to be hostage to finance.

Analysts often lament that governments captured by vested interests do not learn from history. But such behaviour is more than just farcical when history repeats itself within a period of less than four years and when the recessionary consequences of the earlier crisis are still being experienced.

Consider the trajectory that Europe has been through in recent months. When this round of crisis intensification began, it seemed to be a problem with sovereigns that had borrowed too much, as evidenced, among others, by Portugal and Greece. Greece is the one that has gone the furthest in pushing through austerity measures to cajole Germany, France, the IMF and the ECB into providing it credit and to show its resolve to force out the surpluses to repay debt. But, as any sensible economist should have expected, the contraction in output that the austerity resulted in curtailed government revenues and widened the deficit, adding to debt rather than reducing it. Soon there were signs of contagion, with financial markets expressing fears of sovereign default by countries as important as Spain, Italy and even France.

It was at this point of time that the inevitable was obvious to all except some eurozone governments: a restructuring of Greek debt was needed to begin restoring the viability of its economy. The reason this inevitability was not recognised was the power of finance over governments. Debt restructuring would require bondholders, including the banks that had lent to the Greek government, to take a haircut or a loss of part of the value of the credit they had provided governments. This finance was not willing to accept.

When the first round of negotiations to resolve the Greece problem was completed, the Greeks were forced to accept austerity, some European governments and the IMF offered guarantees and/or financial support, the ECB demurred and offered some liquidity, but missing from the list of burden-sharing parties were the banks. They did not have to face up to an immediate default on their loans to Greece, nor did they have to accept a haircut or even a restructuring of debt involving new loans with extended maturities and lower interest costs.

The refusal of banks to contribute to the settlement was obviously because they were in a state of denial, not recognising that sovereign default was in the realm of possibility. To bolster their no-penalties position, they referred to the possibility of bank failure and a financial collapse. Their intransigence was encouraged by the rating agencies that not only started downgrading debt across Europe but also threatened to declare full or selective default on Greek public debt if banks were required to take even a partial hit. Finally, the fact that European unity itself was fragile came to the fore. Though Germans benefited from their country's export success within a unified Europe, they joined the French, the Finns, the Slovakians and others who objected to their tax euros being used to save profligate citizens from countries such as Greece.

The banks were initially clever enough to even protect and enhance their share values. They manoeuvred to ensure that the stress tests of European banks undertaken in July were set up to be extremely favourable to their interests. Only eight of the 90 banks tested failed. Moreover, the possibility of sovereign default was ignored. As a result, most banks came through with very good results and even those that were damaged were only lightly hurt.

However, things have taken a decisive turn in recent times because of pressure on the banks from different directions. An increasing number of sovereign debt downgrades, declining share values, inadequate funding access and private defaults have made it impossible to hide the truth. With the crisis imminent, the soft option everybody is choosing is to focus attention on the governments that borrowed rather than on the banks that lent. But as the governments sink and banks move towards collapse, the nightmare of 2008 is back to haunt the world.