Europe’s Financial Wasteland

PARIS-April is the cruelest month,” wrote T.S. Eliot at the beginning of his great poem, “The Waste Land.” But, if Eliot had been a professional investor who had observed European financial markets over the last few years, I am quite certain that his choice would have been August. In August 2007, the decision by BNP Paribas to close two of its hedge funds exposed to the subprime sector precipitated a liquidity crisis for all European banks during that summer. This year, BNP’s great rival, Société Générale, has been in the spotlight. Its stock fell by more than 14% in one day in mid-August, plumbing depths not seen for two and a half years. Rumors have swirled about a possible downgrade of France’s sovereign debt, accompanied by speculation about the consequences for French banks. Since the French, of all continental Europeans, most respect the convention that no useful work should be done in the month of August, this is harsh treatment for their bankers. They have not been slow to claim that they are being singled out unfairly. They have a point. France is not the epicenter of the eurozone crisis. There is much – too much – competition for that position. Greece was an early favorite in the race to claim it, but faced a stiff challenge for a time from Ireland. Portugal made a sprint towards the front, but is now falling back a little, with Spain and Italy moving up. France likes to think that it is at the back of the field, strolling leisurely in lockstep with Germany. The evolution of the crisis has, however, thrown European banks’ balance sheets into sharp focus. Eurozone governments have proven unwilling, or unable, to produce a solution that persuades markets that they are on top of the problem. It seems inevitable now that either the eurozone will have to contract, with parts of the uncompetitive periphery dropping out, at least for a time, or that member countries’ debts will have to be collectively guaranteed, which implies some form of fiscal union. Nothing less will persuade investors to go near debt issues from the eurozone’s fiscally challenged members. The political problem is that the second solution cannot yet be sold to German voters, let alone to nationalist fringe parties like France’s National Front and Finland’s True Finns. Perhaps it will be possible to persuade the Germans if the alternative is eurozone collapse, which would put the Deutschemark, or a Northern Euro, in the uncomfortable position that the Swiss franc occupies today – too strong for its own good. But things might have to get worse before the political mood swings. In the meantime, the European Council continues, as the Americans would put it, to “kick the can down the road.” Of course, the can is not in the road; it is in the banking parlors. EU banks are holding sovereign debt that clearly is not worth 100 cents on the euro. But even the financial “stress tests” conducted by regulators did not require the banks to acknowledge that inconvenient truth. Many eurozone banks have made far less progress in strengthening their capital adequacy and liquidity than have American and British banks since the financial crisis erupted. The disparities were exposed in the IMF’s last Global Financial Stability Report, published in April, which contains a striking analysis that shows the changes in tangible common equity over the last two years, and the degree to which banks are reliant on wholesale funding. One EU central banker described this to me as the “killer chart.” What it shows is that banks in the United States have increased their equity from about 5.5% to about 7.5%, and have reduced their reliance on wholesale funding from 30% to 25%. British banks have made less progress with tangible common equity, rising from just under 3% to a little over 4%, but they have significantly reduced their reliance on wholesale funding, from almost 45% in 2008 to less than 35% now. By contrast, eurozone banks have almost stood still on both indicators. Their capital has risen a little, but remains below that of banks in the United Kingdom (and well below that of US banks), and they continue to depend on the wholesale markets for almost 45% of their total funding. That is why continuing uncertainty about the integrity of the eurozone, and the value of its members’ sovereign debt, is proving so damaging to its banks. Will it be possible for them to rollover their market funding in these circumstances? Already, the Greeks and the other countries subject to special measures have been shut out of the wholesale markets, and are reliant almost entirely on the European Central Bank. Might that happen to banks elsewhere? In 2007-2008, the sins of the bankers were visited on the politicians; now the reverse is true. Perhaps there is a difference: the bankers’ sins were sins of commission, while the politicians’ sins – repeated failed efforts to produce a solution to match the scale of the problem – are sins of omission. But the consequences are equally grave. I have always assumed that the Germans would eventually recognize that their interests lie in preserving the eurozone intact. As Churchill said of the Americans, “you can always rely on them to do the right thing... once they have exhausted all possible alternatives.” The Germans have now almost run out of alternatives. If they do not do the right thing soon, there will be some banking casualties, and European governments will once again be obliged to put in public money. That will be just as unpopular as bailing out the Greeks, and probably much more expensive. Howard Davies, a former chairman of Britain’s Financial Services Authority, Deputy Governor of the Bank of England, and Director of the London School of Economics, is a professor at Sciences Po in Paris.