Europe’s insoluble problems

By Felix Salmon
November 25, 2011
calling for massive recapitalization of the banking system:

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Mohamed El-Erian is calling for massive recapitalization of the banking system:

The global financial system is being refined “day in and day out,” El-Erian said, and as a result the balance between public and private is shifting and regulation is altering. “This is not being done according to some master plan,” but in reaction to a series of crisis management interventions.

None of these piecemeal policy moves restored confidence in the markets, he said. What is needed is a coordinated and simultaneous set of policy actions globally in four areas: restoration of credit markets, elimination of deteriorating assets from balance sheets, injecting capital quickly into the banking system, and regulatory forbearance.

Oh, wait, that was El-Erian back in October 2008. But he’s saying something very similar now:

In addition to specifying higher prudential capital ratios, governments must now bully banks to act immediately. Where private funding is not forthcoming, which should now be the presumption for a growing number of banks, recapitalization must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared.

The main difference, here, is the move from “regulatory forbearance” the first time around, to governments forcing “fundamental changes in the way financial institutions operate” today. But either way, this is basically, the bank-nationalization debate all over again.

In the U.S., we didn’t nationalize in 2009. We ended up taking only modest stakes in banks, and getting through the crisis through the massive application of liquidity by the Fed. If the central bank, as lender of last resort, ensures that banks will always be funded, then you don’t need nationalization. It’s a bailout by monetary rather than fiscal means, and it’s a lot friendlier to bank shareholders than nationalization is.

But the problem in Europe is that the ECB is displaying neither the willingness nor the ability to act as a lender of last resort — and in that situation, the only policy action left is for governments to step in and try to backstop the banking system directly. This is a very dangerous road to travel down: it’s basically what Ireland did when it guaranteed the liabilities of the entire Irish banking system, thereby consigning itself to a national fiscal nightmare for the foreseeable future.

So color me unconvinced that the solution to a liquidity crisis is an injection of capital. At best it’s insufficient; at worst it’s unnecessary, and only serves to exacerbate the painful process of deleveraging in a pretty drastic manner. After all, liquidity problems can hit anybody, no matter how solvent they are — just ask the German government. The Bund auction failed in large part because the European liquidity-go-round is utterly broken right now, and it’s hard to see how things would improve if Europe’s sovereigns, including Germany, started getting into the banking business.

The idea behind sovereign recapitalizations is our old friend Anstaltslast — the idea that if a bank is owned by the state, then there’s an implicit government guarantee on its liabilities. If Europe’s sovereigns started taking substantial equity stakes in their own banks, then there would be fewer worries over bank solvency: it’s almost impossible for a bank to go bust if the sovereign really doesn’t want it to. But in the context of serious worries over sovereign solvency, this tack doesn’t make a lot of sense. Once you’ve nationalized, there’s no real end to the degree to which you might end up being on the hook for the banks you now own: you can’t credibly claim that the banks you own are now so well capitalized that they’ll never need any more money. And in this case, of course, the worries over European bank solvency are worries over European sovereign solvency. You can’t tie these two rocks together, through nationalization, and expect them to float.

El-Erian is very good at explaining the problem which needs solving:

Europe must still stabilize its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.

It seems to me, though, that sequencing matters here. Liquidity is — always — more important than capital/solvency. Give an insolvent bank enough liquidity, and it can live indefinitely. Remove liquidity from a bank, and it dies immediately, no matter how solvent it might be or how high its capital ratios are. And as for asset quality, we’re pretty much talking a zero-sum game here: when the banks’ dubious assets are the sovereign’s liabilities, the real solution is inflation, not nationalization.

And as for banks’ non-sovereign assets, good luck with selling those. The shadow banking sector knows exactly what happens to asset prices when sellers put €5 trillion of those assets on the market at once, and there’s literally no one out there who would dream of buying such things at or near par.

In every crisis there’s a point of no return — if you don’t do XYZ in time, it’s too late, and the crisis is certain to get out of anybody’s control. I’m increasingly convinced we’ve already passed that point of no return in Europe. The banks won’t lend to each other, the Germans won’t do Eurobonds, and the ECB won’t act as a lender of last resort. The confidence fairy has left the continent, and she isn’t about to return. Which means, as we used to say in 2008, that things are going to get worse before they get worse.

22 comments so far

Some nice points. I’d add: To some degree, the ECB has provided, and is providing, substantial liquidity to European banks. True, Dexia is requiring some sort of fiscal-based solution, but, on the other hand, the news this week that the ECB is considering much longer loans to banks is a sign that it sees an increasing need for liquidity — and will meet it. Also, it’s hard to compare the ECB’s predicament today to the Fed’s in 2008. The Fed sensed there were enough good assets on bank balance sheets that, once investors did the loss calculations, they’d come back and supply liquidity once the Fed’s emergency facilities expired, and the banks had been recapitalized. But the ECB is in a much tighter spot. If you haircut the PIIGS sovereign exposure of many big European banks you’d likely get losses that would require not only sizable equity injections but also heftier liquidity support. More important, by supplying immense amounts of new funds to the banks to forestall a financial sector collapse, the ECB would be going a long way toward bailing out sovereigns, which it says it doesn’t want to do. Maybe that’s the way the ECB will go: Massive liquidity support for banks, so they can keep buying sovereign debt. The only problem with that is that the sovereign debt ends up at the ECB as collateral for that liquidity support. So, not sure what really happens here…

Posted by PeterJEavis | Report as abusive

Interesting that the IFO index in Germany went up recently, indicating increased confidence from Germany’s business leaders…

Posted by FifthDecade | Report as abusive

All 30 of the just named SIFI Banks are in better position today than in March of 09.

The violent re-ordering of global financial system cannot be stopped. Better educated South Korean’s who work 10 more hours per week make half what we do in the United States. If something can’t go on forever it probably won’t.

Posted by y2kurtus | Report as abusive

Providing liquidity to insolvent institutions is now outside the Fed’s legal authority under Dodd Frank. Why are we even talking about it?

Posted by maynardGkeynes | Report as abusive

Hey, here’s an fiendishly clever idea! Let’s chop the crap up into even smaller pieces and mold it into rib shapes. Why hasn’t anyone thought of this years ago?

“It’s not just about selling,” said [Barclays Capital] Marsaglia. “Banks are also looking at ways of re-evaluating the risk weightings of some assets by pooling them together and in some cases people are securitising those pools to get better ratings. There is a lot of work going on around that right now.”

Yes, he actually emitted that quote this week.

Posted by melior | Report as abusive

melior, you can’t make chicken soup from chicken poop. But if all you have is a steaming pile of chicken poop, then what choice do you have?

Posted by TFF | Report as abusive

Mr. Salmon:

I concur that among the liquidity / asset quality / solvency trio, liquidity is primary for the immediate health of the banking system.

However, I believe Mr. El-Erian has a point: unless you fix the latter two (via debt restructurings, recaps, carve-outs, or even debt-for-equity swaps), than the liquidity you end up injecting perpetuates a zombie financial system *which is still prone* to intermittent liquidity crises, big and small (ask the Japanese about this one). To achieve a complete solution, one that gets Europe *growing* again such that it can (someday) move out of its sovereign solvency problem, all 3 must be tackled in tandem … put differently, Europe and other global bond markets are stuffed full of money (look at the base money supply; look at the global benchmark yields in US, Germany, Japan — never lower!), but the broader markets still lack liquidity because core solvency is lacking.

Posted by Dr_Stonewafer | Report as abusive

I don’t see much problem with Europe as general. Spain just got a new government that was elected based on more austerity measures. Italy at least promises that too. Portugal seems forthright about their effort as well.

The only problem is with Greece. I believe the way many (not all) of them see it is still in cycle (ie no logic): borrow, default; borrow, default;..

I can never understand their circular view:
Nobody asks them to pay the principal yet, no body asks them to pay the interest yet. In fact, their budget minus debt servicing and debt repayment is still in deep red. The troika is giving them FREE money right now!!

It’s like the bank tells a family to cut down on the spending, not asking to pay mortgage interest, and not even mortgage lump sum, give the family $3000 a month as help.. and the family keeps screaming at them.
What are they protesting?

Perhaps a good way to show that the old way of cycles is bad and primitive way is to let Greece leave and do it their own circular way on their own in isolation. And then let everyone else see the difference in the long run?

Posted by trevorh | Report as abusive

trevorh – I go along with that.

Apart from that:
“The Bund auction failed in large part because the European liquidity-go-round is utterly broken right now…” – well, to tell the truth, I think there is a much simpler reason for the Bund not selling. It only takes boycotting one or two of these auctions to give people the impression that things are bad and to scare everyone. And that’s what it really is, scare tactics. The market wants to force the ECB to issue Eurobonds, so that the system (the big banks) can start exploiting the European taxpayer. And I am with Merkel here – Eurobonds are not the solution for Europe’s problems. They only postpone/replace a real solution to these problems, and it would btw. mean doing the same the US has been doing the past 50 years.
It’s not a liquidity problem we are having, as you will see when the stockmarket jumps up by 10% again within a week or two, as it did in October. The money is there. They just wanna keep us and the politicians on our toes.

Posted by Rhino1 | Report as abusive

Disagree with Rhino1 on that point.

I don’t know on what sort of thinking you can conclude that European taxpayers are being exploited. And I am not dumb.

The market is doing something that is normal, they worry about the sincere effort from the governments to go back to balanced budget. I think that’s entire legitimate and constructive. Eurobond might be, might not. If there is less politicians/fraud like Samaras, it might be. At least that’s my opinion.

There might be more going behind the scene.
But thinking about it again and again, the root problem is government’s deficit. Fix government deficit and things will go away. No need to worry about all the sugarcoated scheme with liquidity, recapitalization, blah blah. Just fix the root of the problem. It’s the source of other non-economics related problems in Europe too.

Posted by trevorh | Report as abusive

“In the U.S., we didn’t nationalize in 2009. We ended up taking only modest stakes in banks, and getting through the crisis through the massive application of liquidity by the Fed. If the central bank, as lender of last resort, ensures that banks will always be funded, then you don’t need nationalization.”
The above quote is, unfortunately, delusional thinking and all to typical I’m afraid. There is so much wrong with all that implies but rather than blathering on I will just state that we never got through the crisis of 2009 and anyone who believes that we did simply drank the Kool-Aid.

Posted by Mbuna | Report as abusive

Europe’s biggest problem is that it’s Europe; i.e. a bunch of countries with little in common culturally or linguistically. Or was the world too stupid to realize that a political union of 15+ countries with different cultures and languages was going to be a iffy financial and political proposition?

Posted by mfw13 | Report as abusive

“It’s not a liquidity problem we are having, as you will see when the stockmarket jumps up by 10% again within a week or two, as it did in October.”

Isn’t this the definition of a “liquidity problem”? Solvency problems are not solved overnight.

“we never got through the crisis of 2009 and anyone who believes that we did simply drank the Kool-Aid.”

We got through the liquidity crunch. Solvency problems and fiscal imbalances take longer to solve.

Posted by TFF | Report as abusive

Solvency and liquidity are related but different. In a solvency issue the party is under-collateralized, while in a liquidity issue is more of an inability to convert assets to cash regardless of cost. With regards to the banks we clearly have a liquidity issue built on years of regulatory gaming of capital requirements. We all know the big banks are insolvent(e.g. BofA, Dexia etc)

El Arien is arguing for a government(taxpayer) injection, but this ignores the fact that capital is available via bond holders. It’s because governments around the world have, for reasons I can only guess, decided to shield debt holders, with the result that banks have negative equity, are insolvent and in need of tax payer injections.

Not only have we done away with debt conversion of bank debt holders, but we’ve also done away with the double liability of stock holders.

When bond holders don’t have risk of loss, the bank managements have less reason to act prudently. This is just more corporatism. Lets’ not forget PIMCO is a debt holder of banks.

Posted by Sechel | Report as abusive

I’ve come around to Dr. Merkel’s approach on this. She is faced with saving the banks or preserving democracy. The German People decided not to give the government the authority to bail out the EU, and the people are sovereign, not the government.

The EU Commission has lost contract with reality, and is now acting to save itself. Europe is not going to collapse, it will still be there tomorrow. Germany/France/Spain/Etc. are not going to go away, they will struggle but they will still be there in the morning. What is at risk is not the concept of Europe, but the concept of Europe as resident in a few unelected technocrats, and some over-compensated bankers who are facing a very severe loss of stature.

Nigel Farage is correct on this one, there is more at risk here than banks. Germany came to its democracy through a very hard path, but it got there. If it needs to flush the EUC and EUR keep it, so be it.

Posted by ARJTurgot2 | Report as abusive


From my view, I disagree with you entirely.

Merkel is not saving just the bank. Whom are the banks keeping money for?
Right, it’s the people, the pension funds, etc…

If the banks collapse, the deposit collapse, bank run, the people with the deposit will need to be compensated by government insurance. They will need to call in central banks and the inkjet. And after that you have hyper inflation. And you know what often comes after hyper inflation already. Violence, chaos and possibly war.

Just wanting the banks to collapse seems to be shorted-sighted and jealousy minded thinking in my view (no offense intended). Yes I agree bank execs make too much money, and they need to be drag back to reality, but put them on an explosion is too dangerous for everybody else.

We should all think about how to peacefully deflate all the bubles that some of us unknowingly inflated, and some evil within us knowingly inflated.

And the side point of democracy, we have not reached near the perfect point where EVERY person is smart enough to make non-narrow minded decision in a democracy. So the system of perfect democracy is a flaw that will be exploited by some devil. If you want to see how ‘smart’ common people are, just look at the protesters, and of course: Black Friday chaos just passed. For now, we need technocrats who are smart enough to take care. The problem is finding ones that are sincere and capable. As we move closer to perfection, the population will be smarter and we will expand democracy further to best fit the situation. As I always love saying: Impatience for perfection will lead to utter failure, and it looks like we go in just that way.

Posted by trevorh | Report as abusive

Excellent points, ARJ.

Reminds me also of the story of the grasshopper and the ant. The ant toils away, the grasshopper borrows some of the produce to support its relaxed lifestyle. But what is there to borrow against? If the grasshopper wasn’t willing or able to support itself last year, it seems unlikely that it will be able to support itself next year either, even WITHOUT bond payments on top of everything else.

Posted by TFF | Report as abusive

I thought the clearing Banks’ illiquidity was because they’d bought “assets” – land, buildings, etc, bundled or not – at a cocaine driven price, and now those assets are worth about a third (on average) of what was paid.

I wonder if there’s some way everything can shrink and (as far as the horizon) we all seem to be relatively unchanged.

Posted by seymourfrogs | Report as abusive


I think this crisis is not because of that kind of illiquidity. This crisis is in government bond. The kind of assets that you think is precisely ‘government bond’ in this case. Government bond is the thing that is now a third of what was paid. (Certain government wants it to be 0 of what was paid)

A side problem with this crisis is that we simply refuse to accept that we have been in a bubble. We need to deflate it. We don’t deflate to death, that’s bad. We deflate to reality. And we can only do this if everybody accepts some sacrifice (some little, some a lot), stop looking on someone else to take the sacrifices for you!

Posted by trevorh | Report as abusive

Inflating away is just another way of saying defaulting away, just in a more socially acceptable way.

Posted by zhmileskendig | Report as abusive

El Erian’s home country of Egypt is a total shambles economically and could sure use some leadership. It has none and yet El Erian is the world’s best.

If El Erian has any decency and patriotism at all (and he should since his father was an Egyptian diplomat and he owes much to his homeland) he would help lead his country out of an economic situation that is getting more dire by the day for his 80 million countrymen.

The real problem with the global economy is that younger countries like Egypt are so poor, meaning that as Europe ages, the slack is not picked up.

Great men like El Erian, instead of leading, whip up governments to do their bidding while profiting from the process. I suppose it is much less fraught than the processes of trying to squirrel away a fortune while actually leading a country.

Posted by DanHess | Report as abusive

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