Crash in the EU in the next chapter of the financial crisis

By | May 8, 2023

What Central Banks Didn’t Do and Did That Created the Conditions for Collapse

The distinguished economist warns in his article of a worse credit crisis in Europe than the one that hit the US recently Daniel Lacalle, stating the reasons.
As he points out, “according to the Federal Reserve, deposits in US commercial banks have fallen to their lowest level in two years.”
In particular, $500 billion has fallen since the collapse of the Silicon Valley bank.
However, total bank credit has risen to new highs of more than $17 trillion, according to the US central bank.
In other words, “less deposits, but more loans.”

What can go wrong?

The inevitable credit crunch is only postponed thanks to market sentiment that the Fed will provide all the liquidity necessary and that rate cuts are coming soon. However, this is an extremely risky bet.
Bankers are deciding to take more risk on the expectation that the US Federal Reserve will return to loose monetary policy soon, while expecting higher net interest income margins due to rising interest rates, despite the risk increase in non-performing loans.
The fact that the banking crisis has calmed down does not mean that it is over.
The collapse of the banking system is a symptom of a much larger problem: chronically negative real interest rates and an expansionary monetary policy that created many bubbles.
The risk in the balance sheet of the banks lies not only in the reduction of deposits in liabilities, but also in the reduction of the value of the titles.
Banks are so leveraged that they simply cannot hedge the risk of a 20% loss on the asset side, a significant increase in non-performing loans, or the write-off of the riskiest investments.
The level of debt is so high that few banks will be able to raise their capital when things get worse.
Bank runs don’t happen because citizens are stupid…
The largest depositors are businesses, small companies, etc.
They simply cannot afford to lose their cash if a bank goes into receivership.
Once the Fed decided which deposits were guaranteed and which were not, fear reigned again.
Investors and companies in the United States understand this.
However, in the US, 80% of the real economy is financed outside the banking channel.
Most of the financing comes from bonds, leveraged institutional loans, and middle-market loans directly from the private sector.
In Europe, 80% of the real economy is financed by bank loans, according to the IMF.
You may remember back in 2008 when European analysts repeated over and over again that the subprime crisis was a specific event affecting only US banks and that the European financial system was stronger, better capitalized and better regulated.
Well, eight years later, European banks were still trying to recover from the European crisis.

Why are European banks so or more at risk?

European banks bolstered their balance sheets with a highly risky and volatile instrument, hybrid convertible bonds (CoCos).
While they look incredibly attractive due to the high returns they display, they can wreak havoc on a banking firm’s capital when the going gets tough.
In addition, the core capital of European banks is stronger than it was in 2009, but it could deteriorate rapidly in the midst of a bear market.
European banks lend massively to governments, public companies and large conglomerates.
The result of increased anxiety is immediate.
Furthermore, many of these large conglomerates are zombie companies, unable to cover their interest expenses with operating profits.
In periods of monetary excess, these loans appear extremely attractive and carry negligible risk, but any reduction in confidence in the solvency of sovereigns can rapidly deteriorate financial system assets.
According to the ECB, euro area banks’ exposures to domestic government securities have increased significantly since 2020 in nominal terms.
The percentage of total assets invested in domestic public debt amounted to 11.9% for Italian banks and 7.2% for Spanish banks, but also close to 2% for French and German banks.
However, this is only part of the picture.
There is also high exposure to state-owned or state-backed companies.
One of the main reasons for this is that the Capital Requirements Directive (CRD) allows a risk-weighted return of 0% on government bonds.
What does this mean; That the biggest risk for European banks is not the flight of deposits or investments in technology companies.
It is the direct and discovered connection with danger.
It may seem like this has nothing to do with it, but the economy changes quickly, and when the crisis hits, it takes years to recover, as we saw in the 2011 crisis.
Another distinctive feature of European banks is the speed with which the NPL rate can deteriorate.
When the economy weakens or stagnates, lending to small and medium-sized businesses and households becomes riskier, and the lack of an alternative, diversified lending system like the US means the credit crunch can hurt profoundly the real economy.
We can all remember how NPLs rose rapidly from a manageable 3% of total assets to as high as 13% at some banks between 2008 and 2011.
European banks’ assets are exposed to government bonds, deteriorating solvency in small businesses and large industrial zombies.
The latest ECB lending survey shows that, in general, credit standards are tightening for loans to companies, homes and real estate.
But, when the real economy is 80% financed through bank loans and banks are highly exposed to sovereign risks, a ripple effect from a weaker economic environment in the financial system can come from anywhere.
So far, analysts are saying, again, that the banking crisis has nothing to do with Europe because regulation is stronger and capital is stronger, the same thing they said in 2008.
“Depositors have withdrawn 214 billion euros from eurozone banks in the past five months, with outflows reaching an all-time high in February, according to the ECB.
It is not true that bank runs are not a problem in Europe.
The biggest mistake that European authorities and investors can make is to believe -again- that this time is different and that the banking crisis will not affect the Eurozone system”, concludes Lacalle.

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