One of the major themes that I have been discussing in Europe for a long period of time is the simple failure of logic in which the European periphery is being instructed to push deflationary policy onto their economies, yet at the same time expected to meet their existing, and growing, debt obligations. In the most extreme case this has led to what you now see in Greece, but I don’t think Portugal or Spain are far behind. This failing policy is leading to the ‘zombification’ of nations, in which they can’t grow out off their debts yet aren’t being allowed to fail on them either. Kept alive by an ever-growing lifeline of foreign aid when the real solution is to let the beast die and re-build from the ashes. I think if we compare Iceland to Ireland we are beginning to get a clear picture of the benefits of writing off the debts and starting anew.
As I have also spoken about over the last month or so, what is happening in the real economies of Europe is being replicated in the banking system. This is most apparent in the interbank market, as I said:
Although the LTRO does seem to have done some good for short term sovereign debt via supporting direct purchases, or at least the perception of them, it doesn’t appear to be helping in the area that central bank operations actually target. That is, interbank market stability.
The latest ECB data shows that banks parked a near record 446bn Euro in the ECB’s deposit facility, but this in itself isn’t a problem. What is the problem is that the increasing use of the ECB’s marginal lending facility shows that not all of these parked reserves are actually “excess to market requirements”.
What appears to be occurring is that banks are hoarding reserves instead of providing them to the interbank market. If I took a guess I would suggest that this being caused by deposits flowing out of periphery banks into the core (and probably some non-Euro markets). These flows require the periphery banks to recoup some of their lost reserves which they would normally do in the interbank market.
If this is correct then appears that the banks themselves have already decided that there are some “Zombies” in the system. Under these circumstances what should occur is that these banks are identified, assessed and broken up in a structured way in order to purge the financial system of entities that are no longer solvent. Yes, this would mean that investors in those entities would be out of pocket, but that is the risk of investing which is why you get paid a premium. “Dividends” I believed they are called !
However, as I have stated numerous times, the Europeans appear to believe that the normal tenets of investing need not apply on their continent so we continually see policies implemented across Europe to keep the poison in the patient. The ECB’s 3-year LTRO is the latest incarnation of the band-aid to cover the ever-growing wound. Instead of properly stress testing the financial institutions to determine which ones are insolvent and in need of removal, we have an operation by the central bank to provide massive amounts of excessive liquidity. The hope is that this will stabilise the the interbank market and therefore banks will go on their merry way doing what banks do, that is providing credit to the private sector within the bounds of monetary policy.
This approach appears to be failing as, even Mr Draghi has admitted, the interbank market is still frozen. However, even if this wasn’t the case I doubt very much whether periphery banks would be falling over themselves to lend because:
Firstly the banks appear to be using the facility to re-capitalise while at the same time they shrink their asset base in order to meet capital requirements, and secondly, in a poor economy the appetite and/or desire for credit is low and the availability of credit-worthy customers is limited.
In their downgrade of the EuroZone, S&P supported this assessment as they listed credit tightening as their number one reason why they took the downgrade action:
Today’s rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include:
(1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.
So how can this be? How is it that the ECB can provide the banking system with so much money, yet there is still a credit squeeze and therefore a deflationary tendency in the periphery ? Obviously S&P’s point 3 plays a part with government austerity driving an already stressed private sector to save over borrow. I will also note that banks aren’t really ever constrained by reserve liquidity, it is capital and credit worthy clients that they need, however that is also not the full story either.
As I stated above, the financial policies of Europe appear to be that insolvent financial entities must be kept alive at all costs, and in this regard the LTRO is playing its part. One clue to how this is occurring is available from the actions of the Italian government just before the 3-year LTRO commenced:
The Italian Treasury offered guarantees for bonds issued by banks to give them access to ECB liquidity, in a move to lower funding costs. These bonds will stay on the banks’ books until their expiration, according to a ruling announced by Italian Prime Minister Mario Monti earlier in December.
In the lead up to the 3-year LTRO the Italian banks created billions of euros worth of bonds and got their government to rubber stamp them. These bonds were never actually issued to the market, they were simply tossed over to the ECB as collateral to get a 1% loan. So how much did the Italian banks get ?
“It’s a 116 billion euros,” one senior banking source told Reuters. Two other sources confirmed that amount. The Italian figure includes 40.4 billion euros of state-backed bank bonds which were used as collateral for the loans.
So now the Italian banks have an additional 40.4 billion euros with which to purchase government paper, created from nowhere, and backstopped by the very sovereign that would later be the recipient the loan. The ECB’s mandate says that they can’t fund sovereigns directly, but it appears it is fine as long as there is a commercial bank acting as an intermediary and taking their “carry trade” cut. That technical point aside, what this shows is that banks now have a way to re-capitalise independent of the state of their other assets and liabilities.
For Italy, with its private sector in relatively good shape, its banking system may be able to weather the storm. In this particular case this operation is probably more about re-capitalising the banks after their exposures to other periphery nations and about funneling money to the government. However, what you will note is that the banking system can now profit independent of its loan book. So why would it bother taking the risk of lending? In an environment of increased capital requirements and a slowing economy it is far more likely that banks will use this additional capital as a buffer as they shrink down their asset base. In short, more consumption of fresh brains.
Given the relative strength of Italy it is doubtful that these operations were about avoiding the collapse of the commercial banks. That, however, may not be the case for somewhere like Spain. The Spanish banking system still has hundreds of billions of dollars in outstanding loan exposure to its now defunct housing market. Under these circumstances you would expect the Spanish banks to require a significant purging. However, once again, the LTRO prevents this occurring. Spanish banks only need to package up these non-performing loans in some type of eligible vehicle ( possibly with a sovereign rubber stamp ) and present them to the ECB for a 1% loan.
The definition of a zombie banks is:
… a financial institution that has an economic net worth less than zero but continues to operate because its ability to repay its debts is shored up by implicit or explicit government credit support.
I believe that definition fits in this case. The problem for the periphery nations and also the ECB in regard to the transmission of monetary policy is that , as Japan can attest to, zombie banks don’t lend. The irony for Germany and its push to raise the performance of peripheral countries is not lost me.