Sovereign bonds were once considered among the safest of all investments. Yet with Greece teetering and several more euro-zone countries on the watch list, the Continent's banks are in trouble. The European Union is struggling to come up with an antidote. By SPIEGEL Staff
The mood was decidedly somber last Thursday as Jean-Claude Trichet put in his last appearance as the president of the European Central Bank (ECB) following a meeting of the institution's governing council. There was no farewell gift and no bouquet of flowers -- only a few words of praise from Jens Weidmann, the president of Germany's central bank, the Bundesbank.
Trichet briefly acknowledged that he was "deeply moved" by the tribute from his German colleague. Then the Frenchman, who will be replaced by Italy's Mario Draghi at the end of this month as the head of Europe's currency watchdog, turned to the latest casualty of the euro crisis: The banks.
Three years after the collapse of the Lehman Brothers investment bank in September 2008, the crisis is heading toward a new peak. The banks no longer trust each other and, during the past week, prices of insurance policies to protect investors in the event that credit institutions go bankrupt have soared to the highest levels ever observed. Only the central banks are considered safe havens and are flooded with money from financial institutions.
Even US President Barack Obama is anxiously watching as events unfold in Europe. He recently stated publicly that the events transpiring on the other side of the Atlantic currently represent the greatest threat to the American economy. "You must act fast," he told the Europeans, adding that there needs to be a "very clear, concrete plan of action that is sufficient to the task."
Back in 2008, the threat came from America. At the time, the US government allowed Lehman Brothers to go bankrupt -- and unleashed a financial tsunami that drove large parts of the global economy into a recession and cost millions of jobs.
Extremely Precarious Situation
Now, it has become apparent that the danger from the heart of the financial world has not yet been eliminated. This time, though, it is emanating from Europe. With leading politicians and economists saying that the cash-strapped Greeks will soon require substantial debt relief, Europe's financial institutions find themselves in an extremely precarious situation.
Many banks still hold billions of euros in government bonds from Greece and other debt-stricken European countries. If these securities tumble in value, the institutions involved could face bankruptcy themselves. In the financial sector there is a growing fear of a chain reaction -- and of a second meltdown in the banking sector. The supply of money to business and industry could soon dry up, sparking a new credit crunch.
As a precautionary measure, ECB President Trichet has turned on the money pump again. Over the coming months, the banks will have access to virtually unlimited liquidity from the ECB.
Furthermore, European heads of government are debating a new radical program. It has become apparent that a number of European banks will have to be nationalized and plans call for the money to finance this move to come, at least in part, from the European Financial Stability Facility (EFSF), the temporary euro backstop fund.
It was only in early September that Christine Lagarde, as the new head of the International Monetary Fund (IMF), was heavily criticized after she suggested that European banks would need some 200 billion ($267 billion) in additional capital. Now though, following a meeting with German Chancellor Angela Merkel and World Bank President Robert Zoellick last week in Berlin to discuss the banking crisis, it is clear that everyone agrees on the gravity of the situation.
The problems are immense. The European debt crisis involves a type of investment long considered to be one of the soundest available -- government bonds issued by European countries. It is a situation which has taken politicians by surprise as well, as can be seen by existing regulations regarding the assessment of risk posed by sovereign bond investments. When determining how much equity capital banks need as a buffer, the risk of financial loss associated with government bonds is considered to be zero.
In the middle of the year, many banks were already forced to write off 21 percent of their Greek bonds due to the impending debt reduction, known as a "haircut." That, though, likely won't be enough. Greek bonds may soon lose half their value -- if not more.
German financial institutions would likely be able to absorb such losses. The country's 13 largest banks have reduced their Greece-related risks to 5.6 billion.
But what if other European countries are affected by the turmoil? Currently, Italian and Portuguese government bonds are only being traded at a steep discount. If Greece were to default on its loans, the market value of these bonds would plummet even further.
US investment bank JP Morgan suggests a scenario in which Greek bonds have to be written down by 60 percent, Portuguese and Irish bonds by 40 percent and Italian and Spanish bonds by 20 percent on bank balance sheets. Due to these writedowns alone, JP Morgan says that European banks require an extra 54 billion. Analysts at Morgan Stanley even recommend up to 150 billion more in capital.
Signs of Trouble
French banks are particularly vulnerable, as demonstrated by last week's collapse of the troubled Belgian-French bank Dexia. After being bailed out in 2008, it now has to be rescued a second time with public funds from France, Belgium and Luxembourg. The Dexia Group holds 21 billion worth of sovereign bonds from ailing euro-zone countries. BNP Paribas also has more than 20 billion in Italian government bonds on its books while Spain owes the French bank some 2.5 billion. Furthermore, BNP and Dexia together constitute Greece's leading foreign creditor with approximately 4 billion.
France's banks are now showing signs of trouble. The venerable commercial bank Société Générale has lost 50 percent of its share value since the beginning of the year. It, along with Crédit Agricole, was recently downgraded by the US rating agency Moody's. To make matters worse, both banks have Greek subsidiaries that have been dragged down by the crisis.
On top of that, the French will find it increasingly difficult to raise money on a daily basis to meet their ongoing obligations. They are much more dependent than other European financial institutions on cash injections from powerful US money market funds. These investment funds, which manage a total of $1.5 trillion, are specialized in such short-term transactions.
Such lenders, however, immediately cut all lines of credit if any doubts arise over whether they will be repaid. According to the Fitch rating agency, the funds are setting increasingly tighter deadlines. Nearly 30 percent of the French securities traded by the 10 largest US money market funds only have terms of up to seven days. Dexia's rapid collapse shows what happens when the cash flow suddenly stops.
Europe Mulls Forced BailoutsSources of liquidity are already starting to dry up. Since late July, US funds have withdrawn nearly 20 percent of their investments from French banks. Société Générale alone lost nearly 20 billion in financing within just a few weeks this summer.
The situation is even worse for Spanish and Italian banks, which have been largely cut off from this important flow of dollars for some time now. A few weeks ago, the US Federal Reserve and the ECB, together with the British, Swiss and Japanese central banks, joined forces to make dollars available to these banks until the end of the year. Without this regular intervention by the central banks, liquidity would have long since dried up.
Greek financial institutions have been forced to stop financing many domestic businesses and investments. Even many healthy companies now find it almost impossible to borrow money. "This is the death of the Greek economy," Greek Economy Minister Michalis Chrysochoidis grimly commented. The country's banks are first in line for any European bailout program.
Things look significantly better for German financial institutions thanks to the country's robust economic recovery. But banks such as the state investment bank Nord/LB in Hanover and the publicly-owned regional bank Landesbank Hessen-Thüringen (Helaba) have too little equity to weather a major crisis. Overall, German financial institutions reportedly need an extra 20 billion in capital.
Commerzbank was bailed out in 2008 with two injections of capital. It was only recently that Commerzbank CEO Martin Blessing returned the majority of the state guarantees that he had received from Berlin -- but he may have to turn right around and ask the German government for more money.
A Different Story
The Greek debts are not his major concern, though: Commerzbank lent 2.2 billion to the Greek government in late July, and an additional 900 million to Greek banks and other enterprises. "Commerzbank could reasonably withstand even a 100-percent haircut in Greece," says Merck Finck analyst Konrad Becker.
It would be a different story altogether, though, if Italy and Spain ran into greater difficulties in the event of a Greek default. The governments of both countries owe Blessing's bank a total of 11.6 billion. On top of that, there are loans and other financing measures for the private and banking sector amounting to nearly 19 billion.
Should the crisis actually escalate and debt restructuring also become necessary in Spain and Italy, "Commerzbank would certainly no longer be in a position to cope with this alone," says Becker. This would make Commerzbank a candidate for recapitalization. If necessary, the medicine will have to be administered forcibly.
A move to compel banks to increase their liquidity buffers, as is currently under discussion in Brussels, would meet with even more resistance from Deutsche Bank. "We are very well capitalized," said Deutsche Bank CEO Josef Ackermann at an analysts' conference last week in London. He explained in detail that the bank will be able to improve its capital base thanks to billions in anticipated profits, adding that by the end of 2013 Deutsche Bank intended to shed risky securities worth nearly 100 billion. At the same time, however, Ackermann had to admit that the bank will miss its profit target of 10 billion for 2011. Although the bank reduced its risks in Greece, Italy, Portugal, Spain and Ireland to 3.7 billion by late June, it's clear that if other euro countries besides Greece start spinning out of control, things could also get tight for the German market leader.
One analyst at JP Morgan has already put forward a scenario in which Deutsche Bank requires nearly 10 billion in additional capital. Moreover, the analyst argues that the bank's liquidity cushion may be insufficient once regulators introduce new provisions over the coming years. Ackermann cites big numbers in an effort to refute such criticism. He says the bank has obtained 180 billion in liquidity.
There is so much fear of a second banking meltdown that officials in the German Finance Ministry are working to redeploy a tool that already proved itself during the financial crisis of 2008 and 2009 -- the Special Fund for Financial Market Stabilization (Soffin). The fund was able to provide ailing banks with guarantees totaling up to 400 billion. This initiative expired in 2010 and is now only dealing with old cases -- but it would be easy enough to revive it: "All we would have to do is change the date in the text of the law," according to staff members working for German Finance Minister Wolfgang Schäuble. They also think that such a move would be approved by the parliamentarians of the parties in Germany's center-right coalition government.
The topic of bailing out the banks is at the top of the agenda across the European Union, and a fundamental decision on the issue was expected at the next summit of the 27 heads of state and government in Brussels, originally scheduled for Oct. 17-18. Due to ongoing differences between France and Germany, however, it has now been postponed until Oct. 23.
When it comes to banks, the Germans are pushing for all banks in the euro zone and the UK to have a standard capital ratio of, for example, 10 percent. Furthermore, experts in Brussels are considering introducing compulsory aid for banks. This contrasts with existing rules in individual EU countries that provide no means of bolstering recalcitrant financial institutions. According to the new concept, any bank that can't raise enough private capital would be financed from public coffers.
Sources in the German Finance Ministry say that these measures would be limited to banks deemed "too big to fail." In addition, the affected banks would initially be given a deadline to bring their capital reserves up to the required level on their own. "Compulsory capitalization is definitely a controversial issue," says Michael Meister, deputy leader of the conservatives' parliamentary group in the Bundestag.
It is still unclear whether the plan would receive majority support in Germany and the EU. France is pushing for the expanded European Financial Stability Facility (EFSF) bailout fund to quickly and unbureaucratically aid embattled banks with sorely-needed capital. This would be a less conspicuous way of recapitalizing French banks -- and at a lower cost to the French.
'The Faster, the Better'
By contrast, the German government wants to limit EFSF operations to extreme emergencies. The Germans say that initially, at least, the struggling banks would have to attempt to raise fresh capital from private investors. If that doesn't succeed, says Berlin, then the home country will have to step in.
France is, however, not alone in its demand that the bailout fund be used to recapitalize banks. Support for the idea also comes from countries that generally argue for cautious spending of taxpayers' money. Austria, for instance, whose banks are also under threat, does not oppose in principle using the EFSF to support the sector.
Another contentious aspect is Germany's determination to give the Bundestag a say on how the money is spent. The plan calls for the majority of EFSF operations to be subject to the approval of a parliamentary committee. Germany's partners in the EU have expressed reservations about this approach. "A government needs the general confidence of parliament for it to be able to act effectively on decisions that affect the financial markets," says Luxembourg Finance Minister Luc Frieden, "and this is especially true of large countries."
A very different proposal to use the new bailout funds more efficiently has been made by Walther Otremba, a former top official in the German Economics Ministry. In an article in this week's SPIEGEL, the former state secretary proposes creating a Europe-wide insurance for struggling peripheral countries like Portugal, Italy, Spain and Ireland. According to Otremba, the concept would be financed from the risk premiums of the associated bonds -- and would provide a way of preventing the contagion from spreading to other members of the euro zone should Greece default.
Speaking in Berlin last Thursday, ECB President Jean-Claude Trichet made it clear that he thought domestic programs should be used first to strengthen the banks' equity capital base. He added that the EFSF bailout fund would soon be in a position to lend money to the member states to recapitalize their banks. "The faster the EFSF can tackle the root causes of the crisis," Trichet said, "the better."
Translated from the German by Paul Cohen
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