Europe's Banking Dysfunction Worsens

from Chris Whalen, Daily Reckoning

“While the US and the UK have been mired in political chaos this year, the EU has enjoyed improved economic conditions and some political windfalls. The question now is whether this good news will inspire long-needed EU and eurozone reforms, or merely fuel complacency – and thus set the stage for another crisis down the road.”

Philippe Legrain
Project Syndicate

This week The Institutional Risk Analyst takes a look at recent reports out of the EU regarding a proposal to “freeze” the retail accounts of failing European banks.  The original story in Reuters suggests that our friends in Europe actually think that telling the public that they will not have access to their funds, even funds covered by official deposit insurance schemes, is somehow helpful to addressing Europe’s troubled banking system.  Investors who think that Europe is close to adopting an effective approach to dealing with failing banks may want to think again.

Judging by the reaction to the story by investors and on social media, it appears that the EU has learned nothing about managing public confidence when it comes to the banking sector.  In particular, the idea that the banking public – who generally fall well-below the maximum deposit insurance limit – would ever be denied access to cash virtually ensures that deposit runs and wider contagion will occur in Europe next time a depository institution gets into trouble.

“The plan, if agreed, would contrast with legislative proposals made by the European Commission in November that aimed to strengthen supervisors’ powers to suspend withdrawals,” Reuters reports, “but excluded from the moratorium insured depositors, which under EU rules are those below 100,000 euros ($117,000).

While some Wall Street analysts are encouraging investors to jump into EU bank stocks, the fact is that there remains nearly €1 trillion in bad loans within the European banking system.  This represents 6.7% of the EU economy, according to a report and action plan considered by EU finance ministers earlier this month.  That compares with non-performing loans (NPL) ratios in the US and Japan of 1.7 per cent and 1.6 per cent of gross domestic product, respectively.

But the most basic point to make about the proposal for a “temporary” suspension of access to cash is that such moves never work.  Moratoria are part of the banking laws in Germany and many other European nations, but they are never used because once invoked the institution is dead for all practical purposes.  In Spain, for example, the government had the power to impose a temporary suspension of access to deposits in the case of Banco Popular, but did not do so because it would have killed the franchise.

Jochen Sanio, the former president of the German Federal Financial Supervisory Authority (BaFin), commented about banks subject to “temporary” deposit moratoria that “they never come back.”  Sanio, who guided Germany through the 2008 financial crisis and forced the clean-up of insolvent state-owned banks, was retired and gagged for the rest of his life for challenging Germany’s corrupt political status quo of covert bailouts.

So again, one has to wonder, why any responsible official in Europe would support the plan reported by Reuters.  As the US learned the hard way in the 1930s and with the S&L crisis in the 1980s, the lack of a robust national deposit insurance function to protect retail depositors leaves an entire society vulnerable to banks runs and debt deflation.  Until the EU is prepared to do “whatever is necessary,” to paraphrase ECB chief Mario Draghi, in order to protect retail bank depositors, the EU will remain far from being a united political economy.

Readers may recall the comments of German Chancellor Angela Merkel last Fall, when she suggested that the German government would not support Deutsche Bank AG (NYSE:DB) in the event that the institution got into financial trouble.  At the time, DB was trading at about $12 per share in New York.  We spoke about DB and the ill-considered comments made by US and German officials from Dublin on CNBC on September 30th.

At the time, we reminded investors that political officials should never talk about a depository institution while it is still open for business.  This is a basic, well-recognized rule that has been followed by prudential regulators around the world for many years.  Yet because of the popular political pressures on elected officials such as Merkel, the temptation to engage in absurd hyperbole with respect to big banks is irresistible.

We see this latest piece of news out of Europe as further evidence that there is still no political consensus about how to deal with troubled banks.  As we learned last year, Merkel could not even make positive public comments about DB for fear of committing political suicide.

The more recent bank resolutions in Spain and Italy were made to look like touch measures in public terms, even as the Rome government quietly subsidized the senior creditors of two failed banks in the Veneto.  We noted in an earlier comment, “Fade the Great Rotation into Europe,” that the EU pretends to play tough on bank rules while bailing out the senior creditors:

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