Eurozone Finances Have Deteriorated

Eurozone banks are overleveraged

Almost certainly, the concealment of bad debts in TARGET2 has saved the Eurozone’s commercial banks from going under, because they are very highly geared to losses, as the table, of the Eurozone’s global systemically important banks (G-SIBs) in Figure 4 illustrates.

They are ranked from highest shareholder leverage (the end column), being the relationship of their market capitalization to the size of their balance sheets. The balance sheet gearing, that is the ratio of balance sheet assets to balance sheet equity, are all exceptionally high with the French bank, Credit Agricole, being over 30 times. This compares with American G-SIBs which are geared an average of about 11 times. And while the US G-SIBs have a price to book ratio averaging about 1.3 times, none of the Eurozone G-SIBs have a price to book of over one.

Normally, value investors get excited at the prospects for an investment at a discount to book value. But that presupposes that the business is viable and whose shares are mispriced. In the case of these G-SIBs the message is different, being a serious question mark over their likely survival. It is doubly serious because an investor picking up Eurozone bank shares knows they are effectively underwritten by the ECB and the national banks, who would be certain to come to their rescue in the event of a systemic crisis. Yet with this implied guarantee, shares in Société Generale and Deutsche Bank are trading with that value embedded in their share prices.

In other words, there is option value to be had, and little else.

We see banks such as Société Generale and Deutsche having an implied leverage for shareholders of over 60 times. It makes sense to look through these numbers and conclude that so far as the markets are concerned, the Eurosystem’s ability to rescue these banks from collapse may be limited. A rescue of failing G-SIBs is a near certainty, but the terms are not. Furthermore, the threat of bail ins, which are now widely incorporated in G-20 legislation, would leave existing shareholders heavily diluted.

The effect of Basel 4

Basel 4 is the informal name given to Basel 3 regulations concerning risk-weighted assets (RWAs), already delayed and now due to be introduced in January 2023. It is difficult to see how Eurozone banks, particularly the G-SIBs, will be able to comply without reducing their balance sheets.

The aim of the new regulations is to ensure banks’ resilience to crises by prescribing how much capital and liquidity they need to hold by introducing a standardized approach. Banks will still be able to use internal models for calculating the capital required for risk-weighting assets, but they are to be limited by not falling below 72.5% of the figures thrown up by the new standardized approach. The European banking Authority has calculated that the impact of these regulations will cause RWAs to increase by 28%, equivalent to a capital shortfall of €135bn for European banks.

Operationally, European banks are badly affected compared with those in other jurisdictions. Basel 4 discriminates against loans to corporates not independently rated which are uncommon in the US, but not in the EU. External ratings apply to only 20% of European corporates, throwing the emphasis onto lenders’ internal rating systems, which are to be strictly limited. Hence, the need for more capital.

In normal conditions, with bank capitalizations being greater than book value, raising qualifying capital to maintain balance sheet sizes would not be a problem. But as we have seen in our ranking of Eurozone G-SIBs in Figure 4, all their shares stand at a discount to book value.

Senior bankers will already have an eye to these regulations and are unlikely to be prepared to provide the general expansion of credit required to support seemingly optimistic growth forecasts emanating from the ECB. If anything, an Irving Fisher style slump, whereby banks accelerate falling asset values by liquidating them as they fall, has become more likely.

The euro’s fate

The public realization of the situation within TARGET2 and the precariousness of the major banks, plus in the absence of some extremely imaginative accounting the inability of banks to come up with extra capital to satisfy Basel 4 could terminate the European project. In particular, when Germany’s Bundesbank finds that instead of being owed some €1.1 trillion by the other national central banks, she is on the hook for €400bn it will be the last straw for a people whose thrift and savings will have been wiped out. The same can be said for Finland, Luxembourg, the Netherlands, and some of the smaller states.

When one is in possession of the facts the end of the euro is easy to envisage. But early in a crisis, capital flows are likely to enhance the euro’s exchange rate, particularly against the US dollar. This is because of the accumulation of trade surpluses and portfolio flows from EU entities which has increased Eurozone entities dollar exposure. According to US Treasury TIC data, Eurozone holdings of US financial assets totaled $5,339bn and there is a further $1,158bn in dollar bank deposits and money instruments.

Meanwhile, US exposure to liquid Eurozone financial assets and bank balances is far less. Therefore, the rush to liquidity typically seen in a financial crisis is likely to initially favor the euro against the dollar.

Summary and conclusions

In defiance of the terms of the Stability Pact in the1992 Maastricht Treaty, from the admission of Greece and Italy into the Eurozone the history of the euro and the ECB has been one of persistent rule-breaking and cover-ups. Without covid, and without rising prices now almost certain to drive global interest rates higher, the ECB and Brussels might have got away with ignoring some basic rules of statist behavior a little longer.

The crisis facing the Eurozone differs from that facing the US, which, putting aside social factors, is principally the consequence of money-printing. While similar policies have been pursued in the Eurozone, they have not been to the same extent. The problems are more structural, with a banking system that is over-leveraged and reliant on concealing bad debts in the TARGET2 settlement system.

Furthermore, much of the socialism which is relatively new to the US has been embedded in European economies since at least the Second World War, with more than half economic activity being down to unproductive government spending. The cumulative effect of central planning has been to make the economies of EU nations less efficient and through over-regulation divorced from free and efficient markets.

But a final crisis is mounting. After an initial flight out of the dollar into the euro subsides it will be virtually impossible to avoid a wholesale systemic failure, taking down not just the banks, but the central banking network and the euro itself. Some nations will be able to return to their old currencies credibly, but others, particularly Italy and Greece, probably not. And attempts to replace the euro with a new euro and central banking network will face significant hurdles.

The reality is that the euro is the glue that holds Eurozone members together, and without it the European project is effectively dead. The clamour for a return to independent nation-states will be almost impossible to resist, not just for Germany, but for those that value its voice of reason. Middle-Europeans, such as Poland and Hungary are likely to stop their attempts at reforming the EU from within and just leave, and some of the smaller nations which are there for the subsidies will have no reason to stay.

An overly dramatic forecast perhaps, but one that is increasingly likely, despite Draghi’s whatever it takes.

View single page >> |

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated. The article is for general information ...

more
How did you like this article? Let us know so we can better customize your reading experience.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.