Opinion

A cheap cash binge worth noting

Daniel Hanson Researcher, American Enterprise Institute
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These days, billions of dollars is spoken of as pocket change. A by-product of massive government debt burdens and decades of cheap cash from central banks is the notion that, while solvency might be important, liquidity should be easy to find. Particularly for financial institutions, the official state position appears determined to prohibit cash flow issues from developing on a serious scale.

This is particularly important in the case of Europe’s banks, which have massive holdings of southern European sovereign debt that continue to grow riskier and, in the case of Greece, less valuable. The leverage positions of some of Europe’s most prestigious financial institutions, such as Deutsche Bank, exceed 40 to 1 — far greater than the leverage positions of Lehman brothers before its cataclysmic collapse. As a whole, Europe’s banks are leveraged at 26 to 1, at levels far higher than the 13 to 1 position faced by all U.S. banks in 2008. In short, Europe’s banks have massive problems in terms of both liquidity and solvency.

Since the highly leveraged European financial system came under heat in the summer, European leaders have scrambled to buy the banks time to fix their balance sheets. These banks have attempted to make hay while the sun still shines, and thus European banks have regained some health by reducing their riskier operations in other markets. French banks, for example, walked away from a $10 billion Qatari gas project shortly before Christmas in a move to retract credit lines and strengthen fundamentals. Likewise, RBS has shed over $950 billion in assets and has dropped a substantial portion of its investment banking operation.

Still, European banks are facing huge losses on their €3 trillion in suspect loans to sovereigns — roughly 6 percent of all European bank assets — in the next three years. With €725 billion of debt due by year end from nearly insolvent debtor nations, Europe’s banks are climbing uphill as they struggle to meet the European Banking Authority’s requirement that they hold a minimum of 9 percent in core capital, a category comprised predominantly from common stock and retained earnings.

Against this backdrop, the European Central Bank has pumped over €1 trillion into more than 800 of Europe’s banks since the beginning of December. In theory, this funding — some of which was rolled over from earlier ECB operations — is a nudge towards risk taking. The ECB would like to see banks lend to one another and lend to consumers, businesses and governments, alleviating some of the credit crunch that has driven European growth negative. To a certain extent, the program has been successful; if the recent Spanish and Italian bond auctions are any indication, banks are more willing to loan to sovereigns at reasonable rates.

Two extremely disconcerting features undermine the effectiveness of such an approach, however. Firstly, the ECB needs banks to reduce their leverage positions so as to reduce the impact of sovereign defaults on financial markets over the next several years. The current liquidity operations have forestalled a Lehman-style collapse for the moment, but by edging up risk appetite for sovereigns, the ECB has simply kicked the can down the road. Old habits die hard, and even after the Greek write-down debacle financial institutions are still incentivized to buy debt from countries that will be unlikely to repay it at full value. If the banks fail to have their loans to debtor nations repaid, they will find repaying their ECB loans to be a Herculean task.

Secondly, there is considerable evidence that the lion’s share of funding is simply being parked at the ECB. Since August, the use of the ECB’s deposit facility has more than quadrupled, with funds in excess of 80 percent of ECB new long-term refinancing operations being dumped into the facility since early December. Primarily because of the uncertainty surrounding the lethal cocktail of higher EBA core capital regulations and uncertain sovereign debt, banks are sitting on piles of cheap cash that could be called up to combat disasters should they arise, and many banks fear that even the large amount of funding they have been offered so far will not be enough in the event of a real credit emergency.

But so long as this cash is deposited at the ECB, it is doing little to help improve the underlying health of the European financial system, which needs real balance sheet adjustments to reduce strains over the long term. Moreover, since the ECB lends at a 1 percent interest rate and only pays out a 0.25 percent rate on funds in the deposit facility, banks that have borrowed from the ECB are only widening the future funding gap they will face as the debt crisis continues to unfold.

Meanwhile, regulators do not require liquidity assessments when performing bank stress tests. Consequently, the European Banking Association, charged with preventing a systemic banking failure, is unable to stymie rumors about market funding problems and interbank lending pressures. Since banks are loathe to disclose their short-term funding positions, the severity of the crisis looming inside Europe’s financial markets is impossible to know.

The ECB needs to realize that it can push off bank runs by greasing the gears of the financial system, but until these banks answer solvency questions, a systemically sound European banking system will continue to be elusive. If and when sovereign debt crises in Portugal, Spain and Italy intensify, the banks will descend back into crisis with the additional drain of huge ECB loans lingering in the background.

Daniel Hanson is a researcher at the American Enterprise Institute. His research focuses on sovereign wealth management, trade policy, the euro crisis, and other topics of international economic interest.