On October 17, the European Central Bank will announce the results of its Eurozone bank stress test. At best, Europe’s banks will come under long-delayed capital pressure that — while warranted — will have the unintended effect of pushing them out of the markets in which they need to stay for Europe to come out of its prolonged slump. At worst, investors will be so spooked by the confluence of bank, geopolitical, and macroeconomic problems that they’ll run for the exit, prompting another firesale scenario for which regulators are largely ill-prepared. October 17 could thus be a confluence of capital disclosures that create liquidity stress then exacerbated by growing shortages of high-quality assets, leveraged financial markets, and strapped central banks. In short, fright night could come early in October.
The Eurozone situation is the sorry result of years of deceit and delay. It’s worth repeating a bit of not-so-ancient history: The EU faked eligibility standards a decade or so ago to permit Greece and other peripherals to join the Union and adopt the Euro in a burst of political hope that overcame economic reason. Together with legacy members that had similarly over-extended sovereign governments, the peripherals enjoyed a liquid common currency without fiscal constraint or a useful central bank. Markets of course knew better and thus demanded higher prices on risky sovereigns. To compensate for this, weak countries had their biggest banks sop up sovereigns at discount prices, distorting markets and sowing the seeds for an over-leveraged banking sector on the precipice of interbank liquidity collapse.
When Greece blew in 2011, so did this fictitious arrangement. European regulators then did what they knew best and tried to fake it all over again with dud stress tests that fooled no one. The ECB is valiantly correcting for all these mistakes, first with huge liquidity facilities and, now, with a stress test it swears will be the Eurozone’s first credible one. So, on to the October 17 witching hour. To pass this test, many Eurozone banks have restructured their balance sheets by dumping higher-risk corporate obligations in favor of sovereigns. This is doing a lot of macroeconomic damage to any hope for organic recovery, but cramming to pass the test has taken priority over traditional financial intermediation. Any credit-risk worries that could have constrained banks from doubling-down on their sovereign books were, banks and their regulators hope, allayed by low issuance prices. However, bargain-basement prices for Greek, Italian, Spanish, and Portuguese paper not only masked underlying sovereign-solvency problems, but also spiked a still more dangerous yield-chasing bubble and — as of Friday morning – an interbank liquidity freeze in peripheral nations.
Now, even a breath of a flight to quality – and there’s more than a breeze at present due to geopolitical risk – means that bond prices will fall and big banks that hold big books of high-risk sovereign debt are sitting on a whole lot of stress. Mark this stuff to market – which the markets will do under stress even if the ECB doesn’t – and the Eurozone goes back to the bottom.
What’s particularly frightening about this scenario is not only it’s timing in concert with Russia’s Ukraine adventure, but also the spate of critical decisions that must soon be made if global finance is indeed to be meaningfully repaired. October 17 comes just as global regulators are trying to finalize the reform package of tough capital, liquidity, and resolution standards at the November G-20 meeting. The Eurozone is already a reluctant guest at this party – many of its governments have staunchly resisted the toughest of Basel’s rules along with the EU’s efforts to implement them in concert with a disciplined recovery-and-resolution directive. Although the EU has finalized the Basel III capital rules on paper, actual compliance – especially with the leverage standard – is years off and the rest of the prudential rules remain in varying stages of limbo. To be sure, there will be a final, hard-fought resolution standard, but in the first case that could have come under it – the failure of Portugal’s Banco Espírito Santo – Portugal went back to the old days and rescued senior creditors and uninsured depositors. The Eurozone’s banks thus face their stress tests with a toxic mix of high leverage at a time of significant market uncertainty compounded by continuing moral hazard.
If the ECB’s release on October 17 says what it should, then a lot of banks big enough to be domestic, if not also global, systemic banks will be found to be very weak. The ECB will need to tell these banks and their supervisors how quickly they need to remedy this grievous situation and the way out will require a lot of hard work for which fragile markets may be unwilling to wait. Big counterparty banks in and out of the Eurozone could supply some missing liquidity, but only if they believe they could still comply with tough liquidity requirements at the same time, requirements that require them to hold large amounts of high-quality assets to sop up this risk. With these assets in very, very short supply, private-sector liquidity facilities may be hard to find.
Can central banks ride again to the rescue? In the U.S., the FRB would need to reopen the emergency-liquidity and swap facilities sharply constrained by Title XI of Dodd- Frank. In my view, it will do so if it feels it must, but this will come at considerable political cost to a beleaguered central bank and, thus, perhaps be too little and too late. The ECB doesn’t have the Fed’s political constraint, but it shares its bloated balance sheet and, thus, the limits on its own capacity to provide traditional central-bank support in a time of trouble.
My hope is that the Eurozone’s banks are stronger than I think, that geopolitical stress will ease, and that strong U.S. banks and their continued dollar-clearing capacity will tide the global financial system over this frightening abyss. But without real, stringent regulatory requirements combined with a real, functional resolution system, we won’t be better off even if we beat this reaper. Too many rules are phased in over too many years with too many outs, even as shut-down standards are clouded by too little global consensus. The ECB has taken a major step in the right direction by promising to end the fictions that propped up Eurozone banking over the past three years, but it can’t build a stable financial system on its own.
By the time of the G-20 meeting in November, we’ll know if we dodged yet another systemic-risk bullet, but duck-and-cover isn’t a policy. The FSB hopes to finalize an orderly-liquidation framework that bars bail-outs. Given all the stresses on central banks and the financial system’s increasing inability to bolster itself with liquid high-quality assets, it had better.