At a conference in New York at the end of 2008, Obama's economic advisor, Larry Summers made a prophetic remark at an event organized by the Economist. He told an audience of Wall Street executives that we should never assume that bankers ever learn from their own mistakes. "We, as regulators, should never assume that the banks would amend themselves. Since 1960, banks have been in crisis every three years in one part of the world or another."
These words resonated as I watched the hopeless handling by the European banks and governments of what starts to look like the liquidity crisis of 2007 all over again. European banks are increasing the level of their excess liquidities with the European Central Bank rather than trusting each other.
Furthermore, the increase of the yields and the risk premiums of their countries started penalizing the banks in those countries who pay more for their funding than their counterparts.
A liquidity crisis is a credit crisis waiting to happen. It took a few weeks before the summer liquidity crisis of 2007 transformed itself into a credit crisis by the early fall. Seasons seem to matter in finance!
While the strongest US banks saw their stock prices decrease by 20%, European banks saw decreases between 40 to 50% over the last three months. Investor confidence in the equity is already falling in a dramatic and substantial way.
How could European Banks let this happen? Let's examine the factors, many of which led to the crisis of 2007:
• Lack of transparency.Europe was left in the dark to issues plaguing the banks of Greece, Portugal, and Ireland and soon thereafter, Spain and Italy. Further, European governments conducted a series of stress tests which failed to include any scenarios that would affect the value of the core banking relevant assets.
• Political inaction.European leadership neglected to recognize the apparent systemic risks, much like those that were ignored prior to Lehman's collapse in 2007. During that period, the yield on Greek bonds went from 6 to 50%. One-year bonds are now trading at an annual yield of 98%. While this does not represent a direct increase of the cost of financing Greece (which no longer has access to capital markets,) it is an indication of a bankrupt borrower.
• Late action in restructuring the debt. Arguably, criminal, today, the level of sacrifice that the banks will have to bear is 21% of their sovereign exposure. It would have been 5% a year ago. This not only threatens Greece, but also the entire banking system. Joseph Ackermann, while apparently contradicting IMF Director General, Christine Lagarde on Monday, agrees on the fact that banks cannot afford to mark to market their exposure to Greece.
• Ineffective resignation of the Board of Directors. Doing absolutely nothing to insist that bank managements create a livable restructuring solution, they watched silently, without consideration for their shareholders as half the market value of many banks was being lost.
• Sloppy regulation allows proprietary trading. Clearly Europe has not drawn from the lessons of previous crises. And amazingly, banks have managed to convince governments that there was no need to limit proprietary trading to low-risk assets. The same applies to their exposure to hedge funds.
• Basel III capital adequacy rules were watered down.Banks did everything to reduce their need for capital adequacy and moved its application to 2019.
So here we are again, confronting yet another serious banking crisis. And although this time, the Europeans have created it themselves, in Europe, that will not stop them from blaming everybody else. Politics quickly took the place of financial discipline. The cost is in hundreds of billions of dollars. This time, however, governments will not be able to bail them out. They will have to rescue some of their sovereign assets. There is no alternative and Europe will have to pay the price of its own complacency.