No magic potion for eurozone banks

Woman withdrawing money from an ATM Image copyright Reuters

As I mentioned a couple of weeks ago, the biggest short-term risk to the stability and cohesion of the eurozone is that banks in the financially stretched southern European countries run short of cash, as their depositors and creditors withdraw their money faster than it can be replaced by the European Central Bank.

The slow and silent run on banks in Italy and Spain - and Greece, of course - is a reality, according to bankers and regulators, although not yet a lethal one.

It has gained momentum with the rising probability of Greece leaving the eurozone, because that has increased the associated risks of loss from default or devaluation for those with money in banks deemed more likely (than others) to follow Greece out of the currency union.

Interestingly, British banks with subsidiaries in these countries are beneficiaries of this disenchantment with the local banks: they are gaining deposits at the expense of indigenous rivals.

There are three trends:

  1. Foreigners moving their money out of Greece, Italy and Spain, because for them even a small risk of devaluation or default is not worth taking. This is the biggest change to the structure of eurozone banking right now. It matters, because big international banks depend on borrowing from big multinational businesses, financial institutions and wealthy individuals.
  2. Local depositors moving their money out of more vulnerable banks to bigger stronger banks and foreign banks. So in Spain, Santander has picked up deposits from the savings banks. And, as I mentioned, British banks with branches in southern Europe are also seeing an influx of clash.
  3. Locals moving their money abroad, often from the local branch of a Greek bank - for example - to a German branch of the same bank.

In response, two things have happened. There has been an acceleration of work on the creation of a Europe-wide deposit protection scheme. And there has been a flurry of activity in Spain to create the perception that its weaker banks are being strengthened.

However, in both cases, what's going on may be rather less helpful and pertinent than it may seem.

Let's take the deposit protection scheme, for example.

If, as seems likely, the Commission says quite soon that it is full steam ahead to the creation of a pre-funded scheme that would give retail depositors across Europe the confidence that their savings up to 100,000 euros are safe, that might well be a good thing in the long term.

But quite apart from the obvious problem that these things take an age to agree in the detail and then implement, such a scheme misses the point of the current crisis.

It would give no protection against the biggest immediate risk for depositors, which is that the value of their savings could halve in a devaluation.

And, if it were a eurozone protection scheme, rather than an EU scheme, it would not protect against default - because if a country were to leave the eurozone, it would presumably also be obliged to leave the deposit protection scheme.

Now there are lots of interesting and important things to be said about whether the eurozone and the European Union needs more centralised regulation of banks and more centralised protection of depositors for the stability of its banking system in the years and decades ahead. I will come back to those issues later this week - because they have fascinating ramifications for the future of bank regulation in the UK.

Image copyright Reuters
Image caption The Spanish government’s rescue of Bankia may hasten a bailout of the country

But for the immediate challenge of rebuilding confidence in Greek, Spanish and Italian banks, any talk of a pan-European deposit protection scheme is irrelevant at best.

I say "irrelevant at best", because if - as seems likely - any new scheme would leapfrog the putative new protection scheme and retail depositors to the head of the queue for repayment when a bank collapses, there is the risk that banks on the cusp of being deemed vulnerable would find it even harder to borrow from financial institutions, because the status of these non-retail creditors would be downgraded (you may have to read that paragraph a few times for it to make sense - sorry).

And what of the Spanish government's supposedly bold plan to inject 19bn euros of new capital into Bankia, the country's largest pure retail bank, laid low by reckless property lending? Well there is a wonderful story about this in the Financial Times, which - if you are a geek like me - will either make you laugh or cry.

What the FT says is that the financially challenged Spanish government is a bit worried about raising the 19bn euros by selling government bonds in the normal way - because, as probably hasn't escaped your notice, investors have become more wary of lending to Spain, and its borrowing costs have therefore risen very sharply (the implied interest rate on 10-year loans to Spain was 6.4% this morning).

So rather than borrow the 19bn euros from third-party investors in the normal way, the Spanish government wants to give Bankia 19bn euros of its bonds in return for a majority stake in the bank - or so the FT says.

Now you might think this would be a very odd way to restore confidence in either the finances of an important bank or of a rather important eurozone government: one load of government IOUs of questionable intrinsic value would be swapped for a dubious right to future profits in a bank whose foundations have been crumbling.

On the face of it, what would be transpiring is only a little bit better than two individuals on the verge of bankruptcy promising to honour each other's debts.

But it is a bit better than that, because of the magnificent rules of central banking. The point is that Bankia can take those 19bn euros of Spanish government bonds and swap them for cash at the European Central Bank.

Hey presto, as if by magic, problem solved: Bankia would have billions in new capital and cash.

Except that if Bankia has really been strengthened by this financial engineering, then there would have to be a very significant transfer of risk to the European Central Bank - and therefore, by implication, to its shareholders, or the other central banks and taxpayers of the eurozone.

However, the European Central Bank, under its statutes, is not supposed to take that kind of risk. And, on the basis of recent history, it is fair to assume that the Bundesbank and many Germans would go bonkers if they thought they were really being forced to bail out a bank that bankrupted itself by rampant speculation on land and property.

So presumably, if the deal is allowed to proceed, the ECB will ensure that all the risk actually remains with Bankia and the Spanish government - and therefore with Spanish taxpayers - by imposing a massive discount (or haircut) on the amount of cash it would exchange for the bonds.

Which means that the deal may turn out to be too clever by half.

If it creates the perception among Spain's creditors that the Spanish government has secretly recognised that it cannot afford the true costs of strengthening Spain's banks, Spain will find it even harder to borrow. So the backdoor bailout of Bankia could actually hasten the day when Spain asks its EU partners for a bailout.