Return Of The Repressed: Europe’s Unresolved Banking Crisis

The conventional narrative has it backward.  It worries about the threats to stability emanating from the periphery in Europe. Policymakers, investors, and economists still refer to the “Greek, Irish, Portugal and Cyprus’ bailouts.   

The biggest threats don’t come from the periphery but the core.  The peripheral countries were not bailed out, the official and many private sector creditors were made whole.  

I hosted a lunch with a central banker from Italy a year ago.  As we discussed the state of the banks in Europe, he asked,”Who do you think has spent the least amount of money to bailout out its banks, Germany, the UK, or Italy?” Nearly everyone was surprised that Italy has hardly spent a red cent of taxpayers money for such purposes.  

A week ago the IMF warned that the biggest contributor to global systemic risk was Deutsche Bank, followed by HSBC and Credit Suisse. The IMF’s assessment came shortly after the Federal Reserve found that for the second consecutive year, Deutsche Bank did not pass its stress test (Spain’s Banco Santander was the only other bank that failed of 33 tested).  

Our constructive outlook for the US dollar has long been predicated on divergence. In its short version, we emphasize the fact that the ECB and BOJ are still easing policy, while the Fed began the gradual normalization process  In its longer version, we discuss other areas of divergence, including the relative health of the financial system. Whatever metric one chooses, such as profitability, level of non-performing loans and coverage (loan-loss reserves), core capital, and leverage, large US banks are in a superior position to large European banks.  

In the US, the markets are more important than bank lending to corporations. Businesses in Continental Europe and Japan are more reliant on banks as a source of capital. The US moved early and aggressively on both channels of capital distribution.  Europe’s response was considerably slower and less effective. When Draghi talks about the need for structural reforms, many think about labor reforms, pensions, and fiscal reforms, but without a healthier banks, it (capital) circulatory system, it is difficult to envision robust growth in Europe.