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Austrian business cycle theory explains that the “bust” phase of that cycle is created by extension of cheap and plentiful credit by a fractional reserve banking (FRB) system. A FRB system is inherently fragile during the bust phase as its’ leverage(lending as % of own capital) exposes the banks to the emerging tsunami of non-performing loans and impaired collateral that are the manifestations of malinvestment.
Yet, in today’s protected and regulated banking industry, the “bust” phase of the cycle is delayed and distorted by the wide-ranging interventionism of regulators, central banks and governments. The ongoing crisis in the European banking sector is evidence of this. Its’ problems of insolvency are unresolved. The ECB is at the centre of interventionist efforts to stall and mitigate a European banking sector collapse that looks increasingly likely within the next 18 months. 1/
Last week the ECB kept interest rates unchanged at 0.25 %. The exchange value of the euro rose and the mainstream media and financial industry pundits all bemoaned Mr Draghi’s immobilism in the face of worsening price deflation 2/. As my November 2013 commentary indicated 3/, there is growing political pressure on the ECB from southern European governments to launch a new round of Eurozone members’ sovereign bond purchases.4/ , as public debt to GDP ratios are increasing for countries on the periphery; and menacingly high too even for some core member countries.
So why has the ECB President kept his powder dry, and is the European banking crisis contained or still perilously at risk ?
Mr Draghi diplomatically hedged at a press conference, claiming that the data available failed to show definitively a confirmed deflationary trend and that though officially measured price inflation at 0.8% was below the Bank’s mandated target 2%, there was no convincing evidence of a Japanese-style deflation in the Eurozone.
The Bank President’s words are meant to buy time, while two related processes – one political, the other regulatory – play out.
The political process is to determine the how Eurozone governments proceed (attempting) to manage the twin crises of growing sovereign debts and growing systemic insolvency risk in the banking sector. The latest event in that process is the German Constitutional Court’s ruling last week that it does not consider that the ECB has been acting within its mandate when conducting debt monetisation – thus allying itself to the view of Jens Wiedmann the Bundesbank President – although it did not explicitly rule that the ECB broke the German Constitution, preferring to pass the parcel on to the European Court of Justice for a definitive ruling.
These legal challenges are a mere proxy war for the real political one between the “Teutonic” bloc led by Germany and the “Club Med” periphery which currently also includes France.
Which returns us to the ECB, whose Governing Council members are composed of a clear majority from the “Club Med” faction. Knowing he has this majority ready to vote eventually for a new round of asset purchases, Mr Draghi is playing a long game.
With ECB benchmark rates already negative in real terms, he is well aware that reducing nominal rates further does little to encourage bank lending. Even with effectively “free” credit, bank lending to businesses is down; as is inter-bank lending. This lack of lending has multiple proximate reasons, but the fundamental one is banks’ own continuing struggle to remain solvent since the onset of the financial crisis in 2007/08. This is where the newest regulatory process comes in.
The ECB is soon to take on so-called “macroprudential” oversight of the Eurozone banking system – a new interventionist approach championed by the G20, IMF and Bank of International Settlements’ (BIS) to reduce risks of failure in the banking system by imposing higher core capital ratios.
Complementary to the EU Commission’s plans to establish a Banking Union (including a Special Resolution Mechanism –SRM – for “bailing in” failing banks), and the BIS’s work to revise and tighten the Basel Rules on bank capital, the ECB is about to embark upon a massive exercise of stress testing all European banks. 5/ A previous round of such tests in 2010 was ridiculed as far too lax. This time the bar has been set higher. It is expected that some banks will fail the stress test, and interested parties are already speculating which, and attempting to guestimate the likely outcome in terms of new capital requirements . 6/
How rigorous these stress tests are is a critical matter for the ECB. Its’ supervisory responsibility for all Eurozone banks enters in force once the SRM measure is finalised later this year . The benchmarks applied for the tests are themselves partly derived from the work of the Basle Committee on Banking Supervision in defining banks’ permitted leverage ratio. Mr Draghi is the chairman of the Group of Governors and Heads of Supervision which oversees these Basle regulators. Interestingly, they recently relaxed the rules on the definition of banks’ leverage, following feedback from the industry that the new rules would entail banks having to raise at least $200 billion in new capital to comply. 7/
The challenge that these regulatory initiatives attempt to address is the massive build-up of leverage in the banking system as a whole. The Eurozone’s banks are the most vulnerable, but the problem is global. Hence the pivotal role of the BIS in defining a common approach.
What has to be factored in here is not simply banks’ traditional business and real estate lending, important though those are to understanding actual and potential loan losses. Far bigger in scale are the banks’ exposures to the shadow banking sector; their off balance sheet losses; and the recent likely losses on FX futures contracts and interest rate swaps caused by the sell off in Emerging Markets.
Derivatives positions in FX and interest rate swaps are staggering and the total derivatives market is estimated at $700 trillion. Amongst large European banks, Deutsche Bank is said to have Euro 55.6 trillion of gross notional derivatives exposure on its books. This figure is some 200%+ greater than Germany’s annual GDP ! 8/ Note, these are not losses, just exposures. Nevertheless, it would take only a very small proportion of these contracts to turn sour for Deutsche Bank’s entire core capital to be wiped out.
The BIS-defined leverage ratio aims to limit banks’ reliance on debt, using a minimum standard for how much capital they must hold as a percentage of all assets on their books. However, the BIS found that “a quarter of large global lenders would have failed to meet a June version of the leverage limit had it been in force at the end of 2012.” 9/
There is a perfect storm developing then in the European banking sector.
First, there is the increasing likelihood that the ECB will unleash a new round of asset purchases from the banks to flood them with the liquidity they need to buy up their respective national governments’ sovereign bonds and so hold bond yields down.
Second, there is a Eurozone-wide regulatory initiative to recapitalise the banks likely, following on from the results of the ECB’s bank stress tests. Third, there is an increasing chance of a deep stock market correction happening this summer. All three, taken collectively, could trigger a crisis of confidence in the banking sector. An insolvency crisis too should not be ruled out in the event of some large banks failing to recover from derivatives markets exposures in an increasingly volatile currency, interest rate and stock markets environment.
1/ Using technical analysis and Austrian economic theory, it is being predicted that a stock market “crack up boom” is due some time near Christmas 2014, followed by a fiat currency collapse. Before that, a deep market correction is foreseen starting by the summer. see“The Globalisation Trap: full report”, Gordon T Long.com, 2014 01 15
2/ “Split ECB paralysed as deflation draws closer” A. Evans Pritchard, DailyTelegraph.co.uk,7th February 2014
3/ “Eurozone’s Debt Crisis: is the next phase of the ECB’s “large scale asset purchases” imminent ?” November 2013, mises.org
4/ A few days after my commentary was published, the ECB’s executive board member Peter Praet let markets know that stimulus measures were on the menu via comments in a November 13th Wall Street Journal interview. “ ECB Bank Stress Tests: Catalyst Of The Final EU Crisis?”, SeekingAlpha.com, 2013 11 17
5/ “ECB Bank stess tests: catalyst of the final EU crisis ?” SeekingAlpha.com, 2013 11 17
6/ “Eurozone banks face £42bn ‘capital black hole’”, Kamal Ahmed, DailyTelegraph.co.uk, 8th February 2014
7/“Basel Regulators Ease Leverage-Ratio Rule for Banks”, Jim Brunsden , Bloomberg .com, 2014 01 13
8/ “On Death and Derivatives”, 29 January 2014, Golemxiv.co.uk
9/ op. cit., Bloomberg .com, 2014 01 13
The next handout to Greece may include extending the maturity on rescue loans to 50 years and cutting the interest rate on some previous aid by 50 basis points, according to two officials with knowledge of discussions being held by European autorities.
The plan, which will be considered by policy makers by May or June, may also include a loan for a package worth between 13 billion euros ($17.6 billion) and 15 billion euros, another official said. Greece, which got 240 billion euros in two bailouts, has previously had its terms eased by the euro zone and International Monetary Fund amid a six-year recession.
“What we can do is to ease debt, which is what we have done before through offering lower interest or extending the maturity of loans,” Dutch Finance Minister Jeroen Dijsselbloem, who heads the group of euro finance chiefs, said yesterday on broadcaster RTLZ. “Those type of measures are possible but under the agreement that commitments from Greece are met.”
Greek 10-year bonds rallied, with yields falling 33 basis points to 7.96 percent as of 4:02 p.m. Brussels time, the biggest drop in seven months. The Athens Stock Exchange Index jumped 2.4 percent.
New money would help Greece fill a financing gap that has vexed European Union and IMF authorities working to make sure the rescue programs stay on schedule. European Union PresidentHerman Van Rompuy said last month that Greece must continue to tighten its belt even as “the people of Greece are still suffering from the consequences of the painful but nevertheless needed reforms that are taking place.”
Under the eased terms, all the bailout-loan repayments would be extended from about 30 years and rates would be cut by 50 basis points on funds from the 80 billion-euro Greek Loan Facility, which was created for Greece’s first bailout in 2010, said the officials, who requested anonymity because talks are still in preliminary stages.
As Greece seeks to meet its aid conditions and unlock more money from its existing bailouts, it’s also looking for ways to make the most of 50 billion euros that was set aside for bank recapitalization. The country had hoped some money might be left over for other financing needs. That now looks less likely because the Greek banks will need more capital, according to an EU official close to the bailout process.
Greece is contesting requirements on how it should stress-test its banks, an exercise taking place before a European Central Bank review later this year, according to two officials. Hellenic banks face a mandate to keep their core tier 1 capital at 9 percent of risk-weighted assets, which Greece contends is too high. This has led to delays in its bank-assessment process, which in turn will determine how much money the banks need.
To win further easing of rescue terms, Greece is waiting for the EU statistical agency to confirm in April that it had a primary budget surplus, the balance before interest payments, in 2013. That’s the trigger set for possible debt relief. Greek Prime Minister Antonis Samaras said Jan. 30 that Greece’s primary surplus last year was more than 1 billion euros, higher than expected.
‘Not for Now’
Euro-area officials have mentioned the prospect of cutting interest rates further on the Greek Loan Facility part of the bailouts, “but this conversation is not for now,” EU spokesman Simon O’Connor wrote in an e-mail yesterday. He said focus remains on how Greece can meet its current bailout terms.
Samaras’s office declined to comment on the talks for a possible third aid package.
Officials from the so-called troika of the IMF, the European Commission and the ECB are due to return to Athens this month to renew work on whether Greece has qualified for another installment of money.
There are currently no plans for the troika of the IMF, the European Commission and the ECB to return to Athens in the near future because there is no prospect for an immediate completion of the ongoing review of the Greek program, according to two of the officials.
Finance Minister Yannis Stournaras aims for the review to conclude and a loan disbursement to be made before March, according to an e-mailed transcript of comments to reporters.
“Currently there’s no rush to decide anything,” Steffen Kampeter, deputy to German Finance Minister Wolfgang Schaeuble, said in an interview in Frankfurt this week. “We will be presented with all necessary data at the end of April, beginning of May. Only then will we be able to have a clear picture of Greece’s performance.”
To contact the editor responsible for this story: James Hertling at email@example.com
Some very relevant observations from Louis Gave of Evergreen GaveKal
Who Will The Emerging Markets Crisis Adjust Against?
In last summer’s emerging market sell-off, India was very much at the center of the storm: the rupee collapsed, bond yields soared and equity markets tanked. The Reserve Bank of India responded by raising rates while the government introduced harsh restrictions on gold imports. Promptly, the Indian current account deficit shrank. So much so that, in the current emerging market (EM) meltdown, India has been spared relative to most other current account deficit emerging markets, whether Turkey, Brazil, South Africa or Argentina. And on this note, the inability of the Turkish lira, South African rand, Brazilian real, etc. to hold on to gains after recent hawkish moves by their central banks is problematic. Markets won’t be calmed until there is clear evidence these countries’ current account deficits can improve. But how can these adjustments happen?
The problem is twofold. First, current accounts are a zero sum game, so future improvements in emerging market trade balances have to come at someone else’s expense. Second, we have had, over the past year, only modest growth in global trade; so if EM balances are to improve markedly, somebody’s will have to deteriorate.
When the 1994-95 “tequila crisis” struck, the US current account deficit widened to allow for Mexico to adjust. The same thing happened in 1997 with the Asian crisis, in 2001 when Argentina blew, and in 2003 when SARS crippled Asia. In 1998, oil prices took the brunt of the adjustment as Russia hit the skids. In 2009-10, it was China’s turn to step up to the plate, with a stimulus-spurred import binge that meaningfully reduced its current account surplus.
Which brings us to today and the question of who will adjust their growth lower (through a deterioration in their trade balances) to make some room for Argentina, Brazil, Turkey, South Africa, Indonesia…? There are really five candidates:
- China, again? That seems unlikely. Instead, China’s policymakers continue to do all they can to deleverage, despite the cost of a slowing economic expansion. Moreover, mercantilism still rides high in the corridors of power in Beijing and so the willingness to move to a current account deficit is simply not there.
- The US, again? As discussed in our recent book (see Too Different For Comfort), the Federal Reserve’s attitude since the global financial crisis has consistently been one of: “the US dollar is our currency and your problem.” The Fed has been happy to print and devalue the US dollar, leaving other countries to deal with the consequences. The days of the US acting as the backstop in the system are now behind us.
- Oil: In the past, collapsing oil prices have come to the rescue during emerging market crises. Of course, this accentuates problems for the EMs dependent on high energy prices for their growth, but is a boon for others (including India, China, Korea, Turkey). Unfortunately, for now, energy prices are not falling, with some more localized markets, like US natural gas, seeing a surge amid record cold snaps.
- Japan: Japan, which has been such a non-player for twenty years, is once again finding its feet. However, it is doing so by exporting its deflation through a central bank orchestrated currency devaluation. How this “beggar-thy-neighbor policy” will help the struggling emerging markets is hard to see, except perhaps through a) capital flows from rich Japanese savers into by now higher yielding EM debt, or b) import substitution on the part of threatened emerging markets where the end consumers will perhaps replace high priced US dollar/euro denominated imports of manufactured goods for cheaper yen denominated ones?
- Euroland: The currency zone’s slight trade surplus is largely due to Germany. However, Germany’s exports to Turkey, Russia, Brazil, etc., will likely suffer as domestic demand implodes in these countries. In this sense—the euroland will be the likeliest candidate on the other side of the EM current account adjustment. Unfortunately, odds are this will take place through falling European exports rather than rising European imports and/or rising EM exports to the eurozone. This is not a good harbinger for global growth.
In short, either oil collapses very soon, or the US dollar shoots up (with Janet Yellen about to take the helm, is that likely?) or we could soon be facing a contraction in global trade. And unfortunately, contractions in global trade are usually accompanied by global recessions. With this in mind, and as we argued in Eight Questions For 2014, maintaining positions in long-dated OECD government bonds as hedges against the unfolding of a global deflationary spiral (triggered by the weak yen, a slowing China, busting emerging markets and an uninspiring Europe…) makes ample sense.
I just wanted to repost a commentary I wrote about this time last year and sent to a couple of Canadian media outlets (Toronto Star, Globe and Mail, National Post) for ‘publication.’ It was not published by any but it seems as relevant today, if not more so, as it did last summer:
- Canadian Billionaire Predicts The End Of The Dollar As Reserve Currency; Warns “It’s Likely To Get Ugly” (zerohedge.com)
- Why conservatives spin fairytales about the gold standard (blogs.reuters.com)
- Is The Fed Ready To Cut America’s Fiat Life Support? (personalliberty.com)
- Jim Rickards on a Return to a Gold Standard: “The Dollar is Definitely Collapsing”!! (socioecohistory.wordpress.com)
- The (sizable) Role of Rehypothecation in the Shadow Banking System (ritholtz.com)
- Coming Collateral Crisis: Re-Hypothecation To the Point of Exhaustion or Destruction (jessescrossroadscafe.blogspot.com)
- Shut Down the Banksters’ Rehypothecation, The Entire Financial System Collapses Instantly Overnight! (silverdoctors.com)
- Desperately Seeking $11.2 Trillion In Collateral, Or How “Modern Money” Really Works (zerohedge.com)
- [KR448] Keiser Report: Narcissists’ Rally (maxkeiser.com)
- Australia’s turn to enter the currency war? (forexlive.com)
- Daily Pfennig: A New Recruit For The Currency Wars (financialsurvivalnetwork.com)
- Currency Wars and Economic Battles (silveristhenew.com)
- Time for BoC to hike rates says former aide (bnn.ca)
- Bank of Canada should hike rates to pop bubble -former BoC aide (xe.com)
- Bank of Canada’s Carney says eyes three factors as rate hike guide (xe.com)