AMERICAN FUTURE

Fear that a credit crisis will engulf Europe has been steadily mounting and has been much talked about. An article in the New York Times cites several examples of financial institutions reducing their exposures to European sovereign debt and inter-bank lending.

• The Royal Bank of Scotland and pension funds in the Netherlands have been heavy sellers in recent days.
• Earlier this month, Kokusai Asset Management in Japan unloaded nearly $1 billion in Italian debt.
• When a $300 million certificate of deposit held by Vanguard’s $114 billion Prime Money Market Fund from Rabobank in the Netherlands came due on Nov. 9, Vanguard decided to let the loan expire and move the money out of Europe. Rabobank enjoys a AAA-credit rating and is considered one of the strongest banks in the world.
• According to a research report by Goldman Sachs. European banks trimmed their exposure to Italy by more than 26 billion euros in the third quarter, for example. French banks like BNP Paribas and Société Générale, whose shares have been pounded lately because of their sovereign debt holdings, were among the biggest sellers.
• Of the biggest American banks that lend to Europe, about two-thirds have pulled back on lending to their European counterparts, according to the most recent survey of loan officers by the Federal Reserve.
• American money market funds have cut their holdings of notes issued by eurozone banks by $261 billion from around its peak in May, a 54 percent drop, according to JPMorgan Chase research.

If I had been tempted to increase my equity exposure (which I wasn’t), an article posted on wsj.com (no link) this evening would have changed my mind.

In a deteriorating macro environment, European banks are “devising complex and potentially risky” new deals to enable them to continue borrowing from the ECB. According to “senior industry officials and regulators,” these deals, which include behind-the-scenes swapping of assets among financial institutions, could heighten risk across Europe’s already fragile financial system. Faced with a drying up of funding from their normal funding sources, this is a sign that “struggling banks across Europe are preparing for a period of prolonged reliance on financial lifelines from the ECB.” Their problem is that they’re exhausting their supplies of assets—such as European government bonds and certain types of asset-backed securities—that the ECB accepts as collateral and that the banks haven’t already committed to other uses.

In particular, they’re entering into liquidity swaps to obtain “billions of euros worth of assets” that can be pledged as collateral to secure ECB loans. This has some regulators and bankers worried:

By transferring potentially risky assets among a wide range of institutions, the so-called liquidity swaps have the potential to “create a transmission mechanism by which systemic risk across the financial system may be exacerbated,” the U.K.’s Financial Services Authority warned in a July consultation paper.

Last month, the Bank of England hosted a meeting for a small group of risk officers from major international banks. When the conversation touched on liquidity swaps, a number of executives, including a senior UBS AG executive, voiced similar concerns as the Financial Services Authority, according to people familiar with the matter.

This sure brings back memories of contagion-inducing securitized subprime mortgages.

Here’s how liquidity swaps work are supposed to work:

. . . banks transfer illiquid assets such as non-investment-grade loans to corporations or to finance public-infrastructure projects—and which aren’t eligible to serve as collateral for ECB loans—to investment banks or insurance companies.

In return, the investment banks or insurers provide government bonds or other liquid assets that the original bank can use as collateral to secure loans from the ECB. The investment banks apply a discount to the assets they are receiving—shielding them from some potential losses—and receive commissions on the trades.

How large a discount is a large enough discount? Which investment banks are involved? How large is their exposure?

It’s not just memories of subprime mortgages:

At giant French bank Crédit Agricole SA, executives said last week that they are taking steps to “rapidly increase” their holdings of assets that can be pledged as collateral. Among those actions are bundling together large numbers of mortgages and other loans into asset-backed securities that the ECB will accept, according to a person familiar with the matter.

Mortgage-backed securities? Say it isn’t so.

From Global Macro-Risk Outlook 2011-2012: Material Slowdown in Growth (Published November 11)

The material slowdown in the recovery from the 2008-09 global financial crisis and recession has prompted us to revise downwards our growth forecasts for most G-20 economies. Overall, we now expect real growth in these economies to be around 3.1% in 2011 compared with our earlier forecast of 3.7%, and around 3.2% in 2012 compared to 4.0% previously.

Financial market volatility stemming from the escalation of the debt crisis in the euro area and accompanying the US fiscal outlook discussions earlier in the year have affected consumer and business confidence. Combined with ongoing deleveraging efforts in the public and private sectors, persistently high unemployment levels and real estate market weaknesses, these developments have resulted in a material slowdown in advanced economies. We expect that financial market turbulence, fiscal consolidation efforts and banking sector deleveraging will continue to constrain growth into 2012.

The slowdown in advanced economies is in turn triggering a reversal of international capital flows to a number of emerging market economies and a deceleration of world trade. We expect the economic slowdown to spill over into emerging markets. The impact on individual countries and regions will vary: Emerging Europe will be most directly affected by the turmoil in euro area financial markets, while Asia and Latin America will be relatively resilient. There is a significant downside risk to our forecasts for the euro area. We believe that there is a high risk of a euro area recession (defined as two consecutive quarters of negative growth). While the recently announced package of measures provides temporary liquidity relief for sovereigns and banks in the area, the medium-term strategy for addressing the underlying macro-economic anddebt affordability challenges – which remains reliant on fiscal consolidation and competitivenessmeasures to foster growth – is subject to significant implementation risks. Furthermore, the precedent being set with a default in the form of Private Sector Involvement (PSI) haircuts in Greece represents a structural break in the funding costs for stressed or potentially stressed euro area countries. This leaves euro area sovereign and bank credit markets prone to disruption. Additionally, the rising funding pressures and the increased capital requirements for banks are likely to exacerbate the credit contraction already underway.

From A Challenge at the Wrong Time: European Bank Financing Needs Are Set to Peak as Market Conditions Worsen (Published November 10)

While much attention has been paid to the challenges many European banks will face in boosting their capital bases, there has been much less focus on their need to refinance their large volumes of obligations that will mature in the coming months — a time when we expect market conditions to remain difficult. European banks have reacted to wide bond and CDS spreads by limiting issuance: in the year to date, they raised only $200 billion in the capital markets.

Of course, banks have many ways of mitigating their refinancing risk, amongst them shrinking their balance sheets. This is not good for European economic growth, which is another story. Regardless, we think continuing the issuance avoidance strategy will be less tenable in the coming months, when European institutions face a massive level of debt maturity, much of it relatively short-dated government guaranteed debt issued in 2008 and 2009.

European banks have $700 billion in public market debt scheduled to mature over the next nine months compared to $921 billion for the past 18 months. This represents a prospective average quarterly run rate of $230 billion compared to a recent average of $153 billion. The word “scheduled” provides an important caveat — some of the obligations could well have been already been refinanced. Whatever the actual amount coming due between now and next June, the magnitude of the increased amount remains significant.

Aside from shrinking their balance sheets, banks can also mitigate their bond rollover risk by seeking other sorts of funding. However, these options are more constrained than they might first appear to be. Deposits are usually the cheapest source of funds, but stiff competition for them means that “new” deposits for each bank will only available to the system via major banking sector consolidation, strong economic growth, or significant monetary expansion.

As noted, another option for banks to meet the June 2012 9% capital targets3set by the regulators would be to shrink their balance sheets by shedding assets. This could prove problematic. On average, European bank equities are trading at approximately 50% of their stated book value, indicating that there is not a deep market for their assets at their carrying costs.

From European Sovereign and Banking Crisis (Published November 14)

Last Monday’s €3 billion, 10-year bond issuance by the European Financial Stability Facility (EFSF) was met with significantly less demand than a similar bond issuance on 15 June, and priced at 177 basis points (bps) over 10-year German Bunds, versus 51 bps in June. Investors’ cool reaction to proposals to leverage the EFSF’s lending capacity (through partial default insurance and/or a special-purpose vehicle, or SPV) contributed to the weak demand, although fundamentally, these leverage options will not affect the EFSF’s creditworthiness. Both the pricing of the EFSF’s last issuance, and the lack of progress in leveraging its lending capacity, display the limits of the EFSF’s ability to support European government bond markets.The rise in EFSF spreads is an important signal because it reflects a rise relative to the spreads of its Aaa-rated guarantors. In theory, EFSF spreads should be below the weighted average spread of its Aaa-rated guarantors, since EFSF issuance is 100% covered by guarantees from Aaa-rated sovereigns and also benefits from guarantees from non-Aaa-rated member states and from the underlying borrower’s repayment obligation.

. . . this development calls into question the ability of the EFSF to fund itself in the markets at low cost. The success of the EFSF as a tool to stabilize sovereign debt prices and the success of the current euro area-wide support mechanism comes into doubt if that ability is compromised. These concerns are amplified by a lack of progress on the two proposed leverage options as investors remain reluctant on both partial default insurance and an SPV. Against the backdrop of the proposals on Greek private sector involvement, investors expect that the suggested 20% protection (either by collateral or by an equity tranche in the SPV) will not necessarily cover them in case of a default. As a consequence, the proposals are unlikely to generate significantly greater demand for euro area sovereign debt. With its current lending capacity (which is at about €266 billion considering commitments to Ireland, Portugal and Greece), the EFSF cannot meaningfully support the euro area’s large government bond markets. This limits the EFSF’s role as an important pillar of the euro area crisis management strategy.

CNBC says that the release of this report on the European exposure of U.S. banks is what caused the equity market to weaken this afternoon. An excerpt:

Fitch believes that, unless the eurozone debt crisis is resolved in a timely and orderly manner, the broad outlook for U.S. banks will darken . . . The risks of a negative shock are rising and could  alter Fitch’s stable rating outlook for U.S. banks . . . Any prolonged turmoil could negatively affect capital market-related revenues well into the future, not to mention the possible effects on loan portfolios and other revenue opportunities.

. . . Ratings of U.S. banks could be pressured if difficulties in Europe, combined with domestic economic challenges, result in significant incremental revenue pressure, combined with a reversal of positive asset quality trends. U.S. banks have been reporting improving asset quality in 2010 and to date in 2011. This positive trend could change course if contagion effects translate into a slowdown in general economic activity. The U.S. economy already faces continued pressure on real estate and persistently  high unemployment, combined with fiscal pressures at the government level.

How insightful! If this was enough to send the market south, the equity market is on very shaky gound.

There’s some important numbers regarding the exposure of U.S. banks in this post from the Economist Intelligence Unit.

The overall direct exposure of the US financial system to the debt of Greece, Italy, Spain, Ireland and Portugal is about US$147bn, accounting for only 6% of total foreign claims on those sovereigns, according to calculations by Goldman Sachs that are based on data from the Bank for International Settlements (BIS). European banks account for 89% of total foreign claims on the so-called PIIGS governments.

However, the indirect exposure of US banks to problem sovereign debt through derivatives, guarantees and commitments is much higher, totalling around US$493bn. If indirect exposure is included, US banks account for 18% of total foreign exposure. This is equivalent to around 5% of the total assets of US banks. That may still sound low, but losses of that size could cause the collapse of banks operating with low capital ratios. Exposure would also be unevenly distributed, with some banks more vulnerable.

These exposures also leave out lending to shaky European banks. Lending by US banks to French and German banks (which are collectively the largest holders of peripheral euro zone debt) is worth around US$1.2trn. Money-market funds are even more worried about their exposure to European banks. The ten largest US money-market funds alone had outstanding short-term loans to European banks worth US$285bn at the end of August 2011, equivalent to about 42% of their total assets, according to Fitch Ratings.

Money-market funds are already moving to reduce their exposure to European banks: they reduced short-term lending to banks in Europe by 14% between the end of August and the end of September. The resulting stress is clear to see in the European interbank market, where the EURIBOR-OIS spread has widened to levels not seen since the 2008-09 global financial crisis, indicating that banks are getting very nervous about lending to each other.

Deutsche Bundesbank

• Managing macroprudential and monetary policy — a challenge for central banks – From today’s speech by Bundesbank President and ECB council member Dr. Jens Weidmann: [My emphases]

The specific challenge for monetary and macroprudential policy in the current debt crisis stems from the fact, that while both policy goals are affected the possibilities to contribute to crisis resolution are limited. Specifically with respect to monetary policy, there is the substantial risk that involvement in crisis resolution may entail a burden shifting from fiscal to monetary policy, and the ultimately necessary political action to address the root cause of the crisis might be delayed, incomplete, or not happening at all.

One of the severest forms of monetary policy being roped in for fiscal purposes is monetary financing, in colloquial terms also known as the financing of public debt via the money printing press. In conjunction with central banks’ independence, the prohibition of monetary financing, which is set forth in Article 123 of the EU Treaty, is one of the most important achievements in central banking. Specifically for Germany, it is also a key lesson from the experience of the hyperinflation after World War I. This prohibition takes account of the fact that governments may have a short-sighted incentive to use monetary policy to finance public debt, despite the substantial risk it entails. It undermines the incentives for sound public finances, creates appetite for ever more of that sweet poison and harms the credibility of the central bank in its quest for price stability. A combination of the subsequent expansion in money supply and raised inflation expectations will ultimately translate into higher inflation. In a monetary union of independent countries, one additional aspect that is often missed in the current discussion is particularly relevant. Monetary financing in a monetary union leads to a collectivisation of sovereign risks among the tax payers in the monetary union. It is equivalent to issuing Eurobonds. However, the redistribution of such risks and the related transfers between the members of the monetary union are clearly the task of national fiscal policies, and only the national parliaments have the democratic legitimation to make such decisions. For this reason, the Eurosystem’s mandate to ensure price stability rightly involves the prohibition of any kind of monetary financing.

Proposals to involve the Eurosystem in leveraging the EFSF – be it through a refinancing of the EFSF by the central bank or most recently via the use of currency reserves as collateral for an SPV buying government bonds – would be a clear violation of this prohibition. Incidentally a support of this scheme by governments would have also circumvented the parliamentary approval for additional rescue funds provided by Germany. These proposals have met the staunch opposition of the Bundesbank. The current crisis cannot be solved by destroying its stability oriented basis. Hence, I am glad that also the German government echoed our resistance to the use of German currency or gold reserves in funding financial assistance to other EMU members.

It is sometimes requested that Germany should contribute more strongly to international stabilisation. However, in my view the most important contribution at the moment is that Germany remains a stability anchor in EMU with regard to fiscal sustainability and with regard to its stability orientation. For example, the new national fiscal rules in Germany may increase confidence in sound public finances, which I believe is currently more important than any short-lived fiscal stimulus. Therefore, I would advise the German government not to weaken its fiscal stance by spending any revenue windfalls, but rather to continue the timely consolidation of the budgets at all levels of government.

From a short sighted perspective flirting with monetary financing may be perceived as a seemingly easy way out, but policymakers have to implement a true long-term solution to the crisis. The course of the crisis leaves no doubt about what this requires. First, on the national level the determination of the affected countries to return to a sustainable path of public finance and to undertake the necessary structural reforms is required. Second, as such action will inevitably entail painful and initially contentious adjustments, we need a framework within the monetary union which ensures sufficient incentives for the member states to follow this way nevertheless. So far, the decisions taken for crisis resolution within the monetary union have not addressed these issues sufficiently as the recent aggravation of the crisis has shown.

The October summit dealt with a number of important crisis issues. One definitely positive outcome of the summit was the decision to ensure sufficient capitalisation in the banking sector, given that contagion effects are a major reason for the severity of the crisis.

However, as we currently see, even positive outcomes of the summit fall short of expectation without the necessary consolidation and structural adjustments in the countries which are at the heart of the crisis. More generally, the euro area is currently caught up in the fact that its framework has, in the course of the crisis, increasingly lost consistency. This is harming the credibility of the current rescue packages. While risks stemming from undesirable and self-inflicted developments in individual countries have been increasingly communalised by the assistance packages, the ultimate decision-making power has remained on the national level and the conditionality that was intended to rein in national policymakers has been increasingly relaxed.

As a first step, a consistent strategy requires strict conditionality of the agreed financial help to be enforced in order to prevent the incentives to implement painful reforms and consolidation measures from weakening further. In the case of Greece, this must imply that the financial help, which is bound to strict consolidation and reforms, will be halted if Greece decides against the agreed adjustment process. It is an important and promising signal that policymakers from EMU member countries have stressed this point, too. What is often overlooked, however, is that uncertainty about the future of the adjustment programme can quickly make untenable the situation of central banks which continue to provide liquidity to Greek banks.

Furthermore, however, policymakers have to decide which direction the currency union is to take. As I have discussed in more detail in earlier speeches, there are in principle two conceivable ways to a consistent and economically sustainable framework for the monetary union. While the first would be a return to the founding principles of the system, but with an enhanced framework that really ensures sufficient incentives for sound public finances, the second way would imply a major shift entailing a fundamental change in the federal structure of the EU and involving a transfer of national responsibilities, particularly for borrowing and incurring debt, to the EU. Only a clear decision for either option lays the foundation to preserve the monetary union as a stability union in the long-run. It is up to governments in Europe to make this decision.

Institute of International Finance

• November 1 Policy Letter to Group of 20 Summit Leaders — Highlights

With business and consumer confidence at their lowest levels since 2009, the Euro Area is at growing risk of a return to recession—entailing significant spillover effects for other economies worldwide. Against this backdrop, your meeting this week should focus squarely on setting out strong, convincing measures to revitalize global growth. [Emphasis in the original]

. . . it is essential that all parties come together behind the continued active role of the ECB in the secondary government bond market. [Emphasis in the original] This will allow time for national authorities’ adjustment efforts to take hold, and help stabilize markets at this crucial juncture. We would also emphasize that lower ECB policy rates at this point would enhance market stability as well as help bolster faltering regional economic growth.

There is a clear need to restore confidence in Europe’s banking sector, and the recapitalization plans for European banks are seen as a key part of the overall approach to this. But the scope and approach chosen will cause a number of serious problems. First, the market value of the debt of the countries most under scrutiny is likely to decline further as banks unload sovereign bonds. This is contrary to the goal of stabilizing and underpinning the outlook for sovereign debt in Europe. Second, the cost of raising capital in the current environment is prohibitive; European bank equity is trading close to 50% of book value, while the cost of issuing bank debt has risen sharply, by almost 2 percentage points over the past year. For some, new capital is not available in the market at all. Against that backdrop, it is inevitable that many European banks will shrink risk assets [Emphasis in the original] rather than try to raise expensive capital or be subject to forced capital injections. This will add to the financial sector deleveraging and contractionary pressures already evident in Europe. Data through September show that Euro Area bank credit growth remains weak, with lending to non-financial corporates increasing by only 1.4% in the first three quarters of 2011 compared to a year earlier. We estimate that if higher capital ratio requirements were to be met by mid-2012 relying only on retained earnings and a reduction in credit supply, overall credit exposure to the Euro Area private sector would need to decline by at least 5%. It is essential that the higher European capital requirements are a temporary measure as intended, not sustained over time and not seen as a new standard to be imposed more widely. [Emphasis in the original] These measures along with the proposed transactions tax could also result in an increase in financial market fragmentation, intensifying the pressures facing Europe.

A recent IIF study, reinforced by the latest economic and financial developments, provides compelling grounds for being less sanguine about the economic implications of reform. The study concludes that neither bank capital nor long term funding can be raised in the quantities implied by the totality of current requirements without significant cost implications. [Emphasis in the original] This highlights the risk that financial sector deleveraging will continue, with serious implications for the cost and availability of credit, and hence for economic activity and jobs. With unemployment in the Euro Area now at over 16 million—an increase of over half a million in the past six months and nearly 5 million from pre-crisis levels—this is a very pressing concern.

. . . it is essential for the official sector to begin viewing the banking system as an indispensible partner in fostering recovery, rather than an adversary on which it is necessary to impose ever more punitive measures with insufficient regard to coordination, cumulative effects, or interactions. [Emphasis in the original] Regulatory reform is needed and it will be accomplished. But unless it is accomplished in a way which permits banks to play their pivotal role in fostering recovery, the main benefits in terms of future stability combined with global prosperity will be lost.

Bloomberg

• European Banks Cutting Sovereign Bond Holdings Threatens to Worsen Crisis

BNP Paribas and Commerzbank are unloading sovereign bonds at a loss . . . BNP booked a loss of 812 million euros ($1 billion) in the past four months from reducing its holdings of European sovereign debt, while Commerzbank took losses as it cut its Greek, Irish, Italian, Portuguese and Spanish bonds by 22 percent to 13 billion euros this year.

European banks cut their foreign lending to the Greek public sector to $37 billion as of June 30 from $52 billion at the end of 2010, according to the most recent data from the Bank for International Settlements. European banks’ lending to the Irish, Portuguese and Spanish public sectors also fell.

Barclays said on Oct. 31 that it cut sovereign-debt holdings of Spain, Italy, Portugal, Ireland and Greece by 31 percent in three months. The Royal Bank of Scotland said on Nov. 4 that it reduced central- and local-government debt of those countries to 1.1 billion pounds ($1.8 billion) from 4.6 billion pounds at year-end.

Charles Dallara, the Institute of International Finance‘s Managing Director, said:

The market value of the debt of the countries most under scrutiny is likely to decline further as banks unload sovereign bonds. This is contrary to the goal of stabilizing and underpinning the outlook for sovereign debt in Europe.

A note from CreditSights said:

The recapitalization of European banks is also turning out to be a damp squib. This does nothing to fix the main problem of restoring sovereigns’ risk-free status.

From Bloomberg:

Of course they are, according to the conventional wisdom. But James Ferguson of the U.K.-based investment banking firm Arbuthnot has a different opinion:

A banking system that needs to trim assets because of higher capital ratio requirements, when it can no longer realistically raise fresh capital, needs a state backed recapitalisation to fund asset disposal. But history shows that bank recapitalisations provide the catalyst for the credit crunch and a crash in broad money supply. Japan learned this in 1998, the US and UK in 2008 and Continental Europe’s lesson starts now. Most vulnerable near-term are the beneficiaries of short-term lending, like trade finance, which threatens another global trade shutdown and commodity collapse on the scale of the one triggered by the US banks in 2008-09. There are signs that the French bank-funded but Swiss-based commodity traders are already feeling the pinch. European bank balance sheet repair, which will be kicked off by the current recap initiative, will lead inevitably to money supply contraction, which implies the euro zone will need QE to neutralise the impact, or risk outright deflation. This means the euro will come under pressure, particularly from the US$. Bank sector consolidation across Europe is likely to be widespread and will result in mergers, dilutions and even full nationalisations.

• Higher capital requirements, in the absence of fresh capital, necessitate asset contraction

• Forced ‘haircuts’, all other things being equal, also require contraction of assets

• Recapitalisation of an undercapitalised banking system will, over the intermediate term, merely fund the necessary asset contraction, just as it did in Japan (1998), the US and the UK (2008)

Precisely because it presents a distinctly different viewpoint on a highly pertinent and timely issue, this is an interesting and provocative analysis that’s well worth reading.

Financial Times

• Oliver Sarkozy, “Europe’s dithering over banking risks 2008 again” — Try these numbers on for size:

At issue is the overall size of Europe’s banking system and its reliance on the wholesale funding markets. With $55,000bn in assets, the sector is more than four times the size of its US counterpart. As a result, Europe’s banks are primarily funded by the wholesale markets, a much less stable source of financing than deposits. At roughly $30,000bn, the sector’s reliance on wholesale financing markets is roughly ten times that of the US.

Europe’s unsecured bond market was closed in the third quarter to all but a few issuers, demonstrating the unreliability of such sources of funding. Limited access to wholesale markets requires European banks to repay these debts as they come due from internally-generated sources of cash (as opposed to issuing new debt as prior borrowings mature). Assuming a three-year average life to the $30,000bn in wholesale funding outstanding, the European banking system needs to generate over $800bn in cash per month to fund maturing obligations. This is unsustainable.

• Quentin Peel, “Merkel risks crisis plan revolt“

Angela Merkel, the German chancellor, will take a calculated risk on Wednesday by giving the whole German parliament a vote on the latest eurozone crisis measures, before she returns to Brussels to sign off on the deal. Members of the Bundestag had demanded the right to scrutinise the package, including measures to “leverage” the €440bn European financial stability facility – the eurozone’s emergency rescue fund – before giving Ms Merkel a green light to agree anything at the second eurozone summit in four days. Now Ms Merkel’s own party has decided to put the package to the full parliamentary chamber – risking once again a rebellion by a hostile minority in its own ranks – and not simply leave it to be approved behind closed doors by the budget committee, where she has a safe majority.

New York Times

• Jack Ewing & Liz Alderman, “New Unease for Europe’s Rescue Plan“

. . . one of the most concrete results of the weekend talks — a plan to compel banks to bolster their emergency reserves — disappointed expectations and suggested that Mrs. Merkel and Mr. Sarkozy were still hesitant to commit resources to a problem that threatens not only the survival of the euro but the world economy. Banks would be required to raise their reserves by about 100 billion euros ($139 billion) for the euro area as a whole. That sum is at the low end of analysts’ estimates and is well below what many analysts consider adequate to remove doubts about the creditworthiness of European banks and to restore their access to international money markets.

“The key to re-establishing confidence is to reassure markets you have dealt with the weak links,” said Nicolas Véron, a senior fellow at Bruegel, a research organization in Brussels. “It seems the parameters they have agreed on do not accomplish that.” Mr. Véron said the standards applied appeared to be so lenient that even the troubled French-Belgian bank Dexia would not be required to raise more capital, if it were not already the focus of its second government rescue in three years.

One of the main negotiators for the banking industry warned of dire consequences if banks were forced to accept losses against their will. “Any approach that is not based on cooperative discussions and involves unilateral actions would be tantamount to default, would isolate the Greek economy from international capital markets for many years and would impose a harsh burden on the Greek people as well as European taxpayers,” said Charles H. Dallara, managing director of the Institute of International Finance, a banking group. “It would also likely have severe contagion effects, which would cost the European and the world economy dearly in terms of employment and growth,” Mr. Dallara said in a statement. The banks are insisting on assurances that Greece will eventually be able to repay its debts without the help of international bailouts.

Mervyn King is the Governor of the Bank of England. Earlier today, he delivered a speech that, in my estimation, is far more somber in tone than any words spoken by Fed Chairman Bernanke. Perhaps this is a reflection of the more precarious financial position of the U.K., whose economy is even more dependent on the health of the financial services sector than is ours.

Whatever the reason, Governor King’s speech is worth a close look.

“It is surely time,” he says, “to accept that the underlying problem is one of solvency not liquidity – solvency of banks and solvency of countries. The provision of additional liquidity by central banks has bought valuable time, but “that time will prove valuable only if it is used to tackle the underlying problem.”

Following the onset of the financial crisis in August, 2007, it took a year for governments in Europe and the U.S. to be persuaded that the problems of their banking sectors stemmed from massively over-leveraged balance sheets, not from a liquidity shortage. In October 2008, banks were recapitalized. However, says the Governor, the recapitalizations were inadequate, especially in continental Europe. As a result, “the underlying problems of excessive debt have not gone away,” and “markets are now posing new questions about the solvency of banks, and indeed of governments themselves.”

As have numerous others, Mr. King attributes the “unsustainable” debt build-up to “the continuing imbalance between those economies running large current account surpluses and those running large current account deficits.” He expects that the burden of debt “will go on rising” in advanced economies unless and until the imbalances have been resolved.

Due to short-term versus the long-term conundrum, he’s deeply pessimistic regarding the depth and duration of the necessary rebalancing:

When the crisis hit, the starting point was the need for a substantial rebalancing of demand and a repaymentof debt. In the deficit economies, there was an inevitable tension between the short run need to stimulatedemand to prevent rising unemployment and falling inflation, and the long run need to rebalance demandand reduce indebtedness. In January 2009, I described this as “the paradox of policy … almost any policymeasure that is desirable now appears diametrically opposite to the direction in which we need to go in thelong term”. The almost intractable challenge facing policy-makers is how to balance those short-run and long-run considerations. There is a long journey ahead before the world economy returns to a sustainable equilibrium, involving rebalancing and a reduction of debt burdens. For the time being, a significant degree of policy stimulus is appropriate to support demand. But that will delay and exacerbate the size of the adjustment ultimately required. [My emphasis]

The time that was bought through liquidity injections hasn’t been put to good use. Coordinated international action by the G20 countries is now far more difficult to come by than it was in 2008-2009, when, faced by a collapse in world trade, countries “needed no persuasion” of the necessity of policy stimulus.

But it has proved much harder to form a consensus on how to tackle the underlying problems. So, three years later, the imbalances in demand remain. Around the world, short-run stimulus packages of various kinds, and unsustainably low interest rates, have bought time. So far that time has not been used to deal with the underlying imbalances, or the weaknesses in bank and sovereign balance sheets. Four years after the financial crisis began, the foreign exchange reserve holdings of China are substantially larger than at theonset of the crisis. Markets now realise that before the crisis banks were seriously undercapitalised and so react in a volatile way to any news about the health of the banking system. And the indebtedness of governments around the world is certainly greater. Time is running out. [My emphasis]

The reason that time is running out is the “crisis of confidence in some banks and sovereigns.”

Since the summer, there have been renewed concerns aboutthe adequacy of the capital of banks in the euro area to absorb likely future losses, thus jeopardising theirability to raise funds. Wholesale funding dried up for many banks over the summer, and share prices ofEuropean banks are around 35% lower today than at the start of July. A transparent recognition of lossesand a substantial injection of additional capital are necessary to restore market confidence. On its own,however, such a policy will raise difficult political questions about the capacity of the weaker sovereigns to pay for any recapitalisation of their banks. Bank and sovereign solvency concerns are inextricably intertwined. [My emphasis]

At this point, Governor King focuses on the prospects for the U.K. economy. Here, too, he’s pessimistic:

The main impediment to the strategy of rebalancing our economy is markedly slower growth in our major export markets, especially in the rest of Europe. That is why we are treading a fine line between stimulus to demand in the short run, and a rebalancing away from private and public consumption towards exports and import substitution in the longer run. Without monetary stimulus – low interest rates and large asset purchases – there is a risk that growth will stall and inflation fall below our symmetric 2% target. But easy monetary policy, by bringing forward spending from the future to the present, means that the ultimate adjustment of borrowing and spending will be even greater. That is our dilemma, and that of other deficit countries . . . in the absence of rebalancing, globally and especially in the euro area, we could be facing a recovery that is not merely reluctant but recalcitrant. [My emphasis]