The financial crisis embroiling the Eurozone is now well into its second year. In May of 2010 its political leaders temporarily managed “to kick the can down the road” with the establishment of the European Financial Stability Fund (EFSF) of 440 billion Euros. The fund’s purpose was to provide financial assistance to member countries facing economic difficulty.
The August downgrade of U.S.debt by Standard & Poor’s, after the debacle over raising the nation’s debt ceiling, set the stage for a crisis of confidence in the financial markets. With no clear resolution in sight to the Eurozone’s sovereign debt crisis there was grave concern regarding the viability of its banks – the ingredients for the perfect storm.
Financial markets internationally tumbled dramatically, volatility increased markedly and consumer confidence waned. The Dow Jones Industrial Average fell or rose by some 400 points four days in a row. The IPO window slammed shut. Despite a pipeline of some 200 companies that had filed with the SEC not a single company went public in September.
The Eurozone is composed of 27 sovereign countries, each with its own separate banking system. Despite a common currency there is no common treasury; therein lies part of the problem. When the European Union was formed there was no political will to create such an institution. In July, Eurozone leaders agreed to expand the powers of the EFSF in order to stabilize the Euro. Yet it was only last week that the change was approved by all 27 nations, a cumbersome and inefficient process that does not build confidence.
The European banking system differs markedly from that of theUnited States. In large part it has been financed by short term commercial paper much of which has been raised fromU.S.money market funds chasing yield. As the sovereign debt crisis dragged on, many money market funds became unwilling to roll over the paper. This has created liquidity issues for Eurozone banks as this is their prime source of funding. U.S.banks on the other hand obtain a large portion of their funding from a low cost and stable depository base.
Precipitating the crisis of confidence in the European banking system was the realization thatGreecesimply does not have the economic wherewithal to repay in full the 350 billion Euros of debt outstanding. Some 280 billion Euros is held by Eurozone banks and the remainder is held by Greek banks. The question is not whether there will be a “haircut” but how much it will be – the July plan called for 21% but the market appears to be expecting something much larger.
The health of the European banks is now at the forefront of the drama. If the other debt laden Eurozone countries demand the same deal asGreece, the EFSF would prove insufficient. The IMF (Ms. LaGarde was until recently France’s Finance Minister) as well as Ms. Merkel, Chancellor of Germany, and Mr. Sarkozy, President of France, have called for recapitalizing the banks so that they will be able to absorb the likely losses.
Eurozone banks are resisting the push to recapitalize. With their shares trading at significant discounts (50% to 60%) to book value the dilution to existing shareholders would be immense. However, if banks do not raise additional capital to absorb the anticipated losses they will have to shrink their balance sheets and shed assets to reduce their leverage in order to meet new capital requirements. This will translate into fewer and more expensive loans to corporations and consumers.
The impact on the European economies would be huge. According to a recent Financial Times article, Eurozone companies derive some 80% of their financing needs from Eurozone banks as compared to the 30% that U.S.companies receive. With the engine of growth now sputtering, is another Eurozone recession in the offing?