AMERICAN FUTURE

In its lead article, the Economist says that the recent EU summit was “A comedy of euros.”

Once again Europe’s leaders have failed to solve the euro crisis. The new treaty could easily be killed by the markets or by its rejection in one or more euro-zone country. The EU has suffered plenty of disappointing summits without the sky falling in—a good many of them in the past year. But unlike the marathon dispute over a new constitution, the euro is in a race against time because markets are pushing countries to insolvency. As investors and voters lose faith, the task of saving the single currency grows harder. Sooner or later, the euro will be beyond saving.

[...] [The Eurozone's] members could strike a grand bargain that deploys the ECB’s balance-sheet and some form of Eurobond in exchange for fiscal integration. The question is not whether they can save the currency, but whether enough of them are prepared to pay the price. This summit suggests not.

Elsewhere in the December 17 issue:

• “The European Union and the euro: Game, set and mismatch” — What do you get when you mix political differences and inept diplomacy? Britain’s bust-up with the rest of the EU.
• “The Euro crisis: Damned with faint plans” – Euro-zone government bonds have not been made safe—and the euro project remains in peril.
• “European banks: Staggering to the rescue” — Europe’s troubled banks and broke governments are in a dangerous embrace.
• “Economics focus: One nation overdrawn” — Lessons for Europe from America’s history
• “The coalition after the veto: State of the union” — Nick Clegg and David Cameron, and the parties they lead, are deeply divided over Europe. But the coalition is indissoluble for now.
• “Financial services in Britain: The blitz spirit” — Britain’s banks face a battalion of threats, not all of them foreign.
• “Bagehot: How Britain could leave Europe” — British grumpiness about the EU feels familiar; actually, big new dangers lurk.

“Economics focus: One nation overdrawn” provides some interesting links:

• Michael Bordo, “The United States as a Monetary Union and the Euro: A Historical Perspective” (2004)

Our historical perspective leads to the conclusion that Europe achieved monetary union much more rapidly than did the United States but that integration on the real side, especially in the labor market, which ultimately is what is required for the EMU project to be successful, has lagged way behind. The question then arises, will the necessary real side reforms required to foster greater flexibility occur at a pace that will come into play in the face of the vicissitudes of the world business cycle and changing world patterns of activity? Will political will continue to provide the glue to keep the EMU going in the face of slow integration? Will it take the equivalent of the U.S. Civil War to either destroy it or strengthen it? Or will institutional adaptation occur in a learning-by-doing process?. Will adding on 10 new countries to the EMU at much lower levels of economic development help the project like the Louisiana Purchase and the Mexican War did for the United States or will it be like the counter factual exercise of the United States acquiring Mexico and Central America? The historic events basically allowed the United States to expand its territory, provide land for new settlers, and acquire vast resources. The counterfactual exercise would involve adding on a densely populated, culturally different region, at a much lower stage of economic development.

The evidence so far suggests that the best case scenario is guarded optimism. A more likely outcome based on the European response to the recent world downturn is probably not so rosy.

• Michael Bordo et. al., “A fiscal union for the euro: Some lessons from history” (2011)

The history of fiscal federations provides us with a number of conditions necessary for a fiscal union to function smoothly and successfully and thus also the monetary union on which the fiscal union is based. The first and probably the most important condition is a credible commitment to a no-bailout rule for the members of the fiscal union. The second one is a degree of revenue and expenditure independence of the members of the fiscal union reflecting their political preferences. The third condition is a well-developed transfer mechanism to be used in episodes of distress. This transfer mechanism can be facilitated by the establishment of a common bond. The fourth condition is a capacity to learn from past mistakes and adapt to new economic and political circumstances.

The Eurozone was created without an effective fiscal union. The institutions that were established to serve as the foundation for the fiscal union (the Maastricht Treaty and the Stability and Growth Pact) – to discipline domestic fiscal policies – did not function as planned as revealed by the crises and recession from 2007-2009 and onwards. The lessons from the historical experience of the five federal states surveyed by us could be helpful for the Eurozone to avoid disintegration.

A key takeaway from this report (written before the EU summit meeting) is that DB’s views on eurozone crisis resolution differ markedly from those of the German government. From the report:

While we continue to believe that the eurozone’s authorities will do whatever it takes to hold the euro together, the urgency of the need to act has risen sharply. The G20 summit in Cannes in October failed to meet the great expectations it had stirred and was almost entirely overshadowed by the market chaos sparked by the suggestion of a referendum in Greece and the subsequent departure of George Papandreou, the Greek Prime Minister.

The eurozone economy now appears to be sliding into recession which we hope will only last for a couple of quarters, although we admit something worse could happen, especially if politicians and central bankers fail to respond rapidly to the deteriorating situation.

Given the market’s entrenched scepticism, what is needed now is a big ‘Grand Bargain’, way beyond anything we’ve had so far. Indeed, this is the price Europe is having to pay for lacking enough will to date. Unfortunately, the actions required are complex and politically contentious and so will likely be prone to scepticism from markets. The bigger the intended action, the bigger the risk that things go wrong when rigorous implementation is needed.

The following two paragraphs show that Deutsche Bank (1) doesn’t support the German government’s opposition to having the European Central Bank function as the eurozone’s lender of last resort, and (2) unlike the ECB, DB sees deflation, not inflation, as a key risk.

In our opinion, three radical steps are now required. First and foremost of these is a large final buyer of government debt. We believe the European Central Bank (ECB) is the only credible source. The ECB is not allowed to buy primary issuance from governments but can buy bonds on the secondary market, as it has been doing in recent months, while noting it may not be entirely content with that course of action. True, significant purchases could be seen as a contradiction of the ECB’s statute. But the German Constitutional Court recentlydismissed lawsuits taking this line.

We think the inflation risk of such purchases is negligible, given the looming credit crunch and recession in the eurozone. Inflation is not Europe’s number one problem right now. We believe deflationary pressure should be more of a concern. The ECB could pledge to purchase a set volume of bonds, say EUR200 billion worth over the next 12 months. That on its own appears enough to finance Italy through 2012. It would be difficult for the ECB to say it is only buying Italian debt but there is no technical reason why it cannot commit to purchasing a set volume of bonds in the secondary market, exactly as it is doing right now with covered bonds.

We believe the second step needed is a big, deliverable and rapid structural reform package from Italy to convince markets it can pull through the crisis. The package needs to be proven immune from the vagaries of the economic or political cycles.

The bank favors some sacrifice of sovereignty:

Third, we need to see rapid and clear signs from the EU that fiscal integration, involving changes to treaties, is coming. We believe there has to be some sacrifice by member states of sovereignty. An example would be giving the European Council the right to veto national budgets. This is the sort of quantum leap in governance reform that the ECB is asking for.

The ECB will likely demand that if it is to launch significant bond purchasing, it has to see the second and third actions outlined above. If it launches this action without demanding any conditions, the eurozone may look weak because it would be seen to be printing money without credible political change or fiscal control. We note that would likely be poorly received by markets.

But “time is short”:

So the ECB, in our view, will have to make a leap of faith and step up its intervention on the basis of a statement of intent from the eurozone’s governments. Even a treaty revision under enhanced cooperation limited to the 17 EMU members would take several months since it would need to follow national ratification procedures. A replication of the EFSF drama is likely, with heated discussions in at least Finland, the Netherlands and Slovakia. ECB intervention will likely have to be particularly large around the key dates for national debates. Even if governments strive to get the new treaty sorted as fast as possible, we think the summer of 2012 is probably the earliest date.

In the meantime, we believe we need to move from implicit to explicit conditionality. Indeed, in its current form, the ECB’s bond purchasing follows an implicit conditionality with contacts between the ECB and the governments which never are as comprehensive and publicly debatable as memoranda of understanding (MoUs) signed withthe IMF.

This likely creates two symmetric risks. First, that public opinion in the core countries consider that the commitments of the peripheral countries are insufficient to warrant an indefinite increase in the ECB’s balance sheet. And second, that peripheral countries resent the transformation of the ECB into a benevolent economic dictator triggering ultimately a rejection of its support.

From a practical point of view, we think that an emergency European Council should be organised as soon as possible to deliver the letter of intent which could allow the ECB to step up its interventions and act as lender of last resort. Europe remains deeply mired in its sovereign debt crisis, something that is likely to dominate markets in the year ahead, and not just in Europe. The whole world has an interest in the resolution of a crisis that deepened dramatically through the fourth quarter, and enveloped more and more major economies putting European leaders on the backfoot as events threatened to overwhelm them.

Round 3 of Reactions to the EU Summit (and some other stuff)

Writing in the FT, HSBC chief economist Stephen King, raises an important albeit obvious point:

The eurozone deal will fail because it offers no explanation of how, precisely, the German current account surplus [5.7 percent of GDP in 2010] will be recycled if the southern European nations head down the path of fiscal righteousness.

. . . there are only two ways in which the surplus can decline: Either German exports have to fall relative to imports, or imports rise relative to exports.

As I’ve noted on several occasions, Germany policy, influenced by its memory of the Weimar hyperinflation, is myopic:

The first of these options will most likely occur should southern Europe succumb to deep recession. Taken together, Italy and Spain are a more important destination for German exports than the US. Fiscal virtue in the south is all very well but the collateral damage associated with ongoing austerity will eventually hurt Germany and other northern European exporters. It’s not something anyone would seriously wish for.

The second option will only happen if Germany accepts the need to boost domestic demand growth over and above what we’ve seen in recent years. If, however, demand is higher, there’s a good chance that German inflation will also be higher.

But what if neither balance of payments adjustment option transpires? How, then, would Germany recycle its savings?

While investing elsewhere in the world remains a possibility, Germany has shown in recent years that it prefers to keep its investments mostly within the eurozone, opting for the “safety” of investing in a common currency.

Countries which have virtuously delivered fiscal surpluses have, too often, succumbed to financial crisis. For example:

In the late-1980s, the UK ran a budget surplus alongside a current account deficit. Only as the economy began to collapse did policymakers begin to recognise that imbalances within the private sector could be just as damaging as those within the public sector. The UK economy wilted in the face of a rapidly deflating housing bubble.

Then there was Asia in the mid-1990s. For years, policymakers argued in favour of a continued Asian miracle as a result of fiscal prudence accompanied by private sector endeavour. Following the Thai baht crisis, we suddenly learnt all about crony capitalism. It turned out that achieving a fiscal surplus was no guarantee of lasting economic health.

King correctly concludes:

Even if eurozone countries achieve fiscal salvation, they may still find themselves succumbing to economic and financial crises. Until and unless Germany’s current account surplus comes down, the risk of repeated crises will remain very high. The fiscal compact so desired by northern European nations may eventually come through. It is, however, not the right answer. That’s because no one in eurozone policymaking circles bothered to ask the right question.

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The Royal Bank of Scotland (RBS) has a very bearish take. See the Executive Summary of the following document that was published today:

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As I’ve noted before, the contagion is spreading to Eastern Europe, as the deleveraging eurozone banks are succumbing to political pressures to concentrate on their home markets.

The Wall Street Journal reports some examples:

In Poland and Turkey, once coveted by western lenders, at least seven European banks have sold or are looking to sell their local businesses to drum up much-needed cash. Buyers appear to be scarce.

Two of Europe’s biggest banks, Germany’s Commerzbank AG and Italy’s UniCredit SpA, say they plan to cease or scale back lending in some Eastern European countries that previously were priorities. Both banks are under pressure from regulators to come up with billions of euros of new capital by next June.

The situation is feeding consumer jitters. In Latvia over the weekend, Internet rumors circulated that Swedish banks, which control about 40% of the industry’s total assets, were unhealthy and preparing to leave the country. Latvian customers yanked millions of dollars worth of deposits out of banks, including Swedbank AB and SEB AB, spokesmen for the banks said. By Sunday evening, about one-third of Swedbank’s Latvian ATMs were empty.

In Bulgaria, Croatia, Macedonia, Poland, Romania and Serbia, at least 20% of the total assets in the banking systems are held by banks headquartered in Greece, Ireland, Italy, Portugal or Spain . . .

Banks from Belgium, Germany, Greece, Ireland, Italy and Portugal have moved to ditch businesses in Poland, Turkey and elsewhere. Their hope was that the units would garner interest from healthy banks. But the reception so far has been lukewarm.

Austria’s big banks, including Erste Group Bank AG and Raiffeisen Bank International AG, set up big branch networks in Croatia, the Czech Republic and Hungary. Last month, Austrian regulators proposed new rules that will make it harder for them to lend there. The banks will have to finance loans in Eastern Europe with locally gathered funds, instead of by siphoning money from Austria.

In Croatia, 48% of the banking industry’s assets are held by Italian banks and 36% by Austrian banks, according to Fitch. Big western lenders are cutting back, especially when it comes to the big-ticket public-sector projects . . .

Reactions to the Results of the EU Summit Meeting

This is an extremely long post with complete articles from the Financial Times, the Economist, the Guardian, Spiegel Online, and the Centre for European Reform (a British think tank). So as to avoid inserting my own slant on the outcome of the summit meeting, I decided not to post shortened, edited versions.

The articles are below the fold.

Continue reading ‘Opinions and News on the Eurozone Crisis, No. 46’ »

From the Financial Times:

• EU talks on doubling financial firewall
• The fall of the Berlin Wall to a US of Europe
• Why this crisis could run and run
• Debate: Euro end-game (video)
• Sarkozy rides through the storm
• Fast-track ‘fiscal compact’ drawn up
• S&P feels Europe’s ire over ratings threat
• Sovereign downgrade could hit eurozone banks
• Don’t fear a downgrade (video)

While you (and I) were having Thanksgiving dinner (and napping afterwards), the eurozone crisis didn’t take the day off:

Wall Street Journal: The ECB will definitely not become the eurozone’s lender of last resort — Meeting in Strasbourg, Merkel, Sarkozy, and Monti pledged to present a package of proposed changes to the European treaty by Dec. 9 that aim to integrate euro-zone economic policies, but quashed suggestions that the European Central Bank should play a greater role in fighting the region’s protracted debt crisis.

Trying to quell a rift with Germany over whether the European Central Bank should take more-decisive steps to solve the debt crisis, Mr. Sarkozy said he and Ms. Merkel agreed to abstain from making demands on the Frankfurt-based bank. Sarkozy said:

“In the respect of the institution’s independence it’s essential that we abstain from making either positive or negative demands on the ECB.”

German Economics Minister Philipp Rösler, in comments made ahead of the reiterated his strong rejection of common euro-zone bonds, while top government lawmakers didn’t completely rule out their introduction. Rösler made clear the euro zone must first change EU treaties and integrate economic and fiscal policies far more deeply. One lawmaker said some discussions on euro bonds may be continuing, but ruled out their introduction during the current government.

In a budget debate, asking Germany’s lower house of parliament to signal its rejection of the collective bonds, Mr. Rösler said:

“We don’t want euro bonds, because we don’t want interest rates to rise dramatically in Germany.”

Wall Sreet Journal: ECB considers longer bank loans — The ECB is considering offering longer-term loans to commercial banks that are having trouble securing funding in private markets, as officials scramble to keep the debt crisis from freezing new lending.

Officials may extend loans to banks at maturities of two or three years, according to people familiar with the matter. The longest maturity at present is 13 months. The ECB will make that 13-month loan available next month, meaning banks that need it will have secure funding through 2012.

Notwithstanding the agreement reached in Strasbourg, new loans at two to three-year maturities would mark an escalation in the ECB’s role as lender of last resort to Europe’s banks. Despite repeated warnings by top officials of the danger that banks could become “addicted” to central bank credit, the ECB has repeatedly made these funds available on an unlimited basis.

Rising German yields may therefore reflect a growing belief in the introduction of euro bonds; indeed higher yields may make common bond issuance more palatable for Germany. A renewed decline in yields could signal increasing fear of a break-up or widespread defaults, although this again might lead to renewed rearguard action to save the euro.

Financial Times: Lex, “Eurobonds: moral hazard ahead“ – If eurozone nations cannot borrow separately, perhaps they can borrow together. That is the logic behind the common debt issuance idea – eurozone bonds – being mooted by the European Commission. Those in favour could cite Wednesday’s other, more scary development – investors turning their backs on a German bond issue – to bolster the case that more liquid collective debt would help to trump countries’ individual difficulties. It is the very crisis the region is trying to fight, however, that makes the joint bond concept look like whimsy.

Moral hazard, for starters. By offering the likes of Greece or Italy such rewards, eurozone bonds could remove these countries’ incentive to regain lost competitiveness. Nor would these bonds reduce the stock of existing debt. Unless there was a degree of fiscal union and budgetary enforcement in the eurozone that trampled on national sovereignty, investors would rightly be sceptical about buying such instruments. If the yield on eurozone bonds was to become significantly higher than that on debt of the bloc’s triple A states, the project would crumble.

And then there is the clinching argument – that Germany will not accept them. An ersatz form of eurozone bond issued by the European Financial Stability Facility already exists. Anything more ambitious is a non-starter until the crisis has abated.

Financial Times: Sebastian Mallaby, “Germany is the real winner in a transfer union“ – Over the past 18 months, Germany has tried every trick to limit its contribution to the euro bailouts. It has pushed self-defeating austerity onto bankrupt countries. It has called in the International Monetary Fund. It has tried to pass the hat to China. It has discovered an improbable and futile taste for leveraging up the European Financial Stability Facility. But now these tricks have uniformly failed, and the continent approaches the abyss – with Germany itself suffering the humiliation of a failed bond auction. It is time for Germany to decide once and for all: how much will it pay to save Europe?

Germans can reach the sensible answer only if they discard the myth, widely cherished in northern Europe, that peripheral southern countries are the undeserving beneficiaries of a charitable transfer union . . .  The truth is that Germany derives myriad benefits from the currency union. It should pay more to save it.

[...] the currency union that makes adjustment in the periphery so excruciating is the very same currency union that handed Germany its export boom. Rather than condemning lazy southerners, the Germans should share the loot.

[...] As the issuer of Europe’s remaining reserve assets, Germany has enjoyed a flood of capital inflows from the periphery, driving its 10-year government bond yield down to around 2 per cent, this week’s auction notwithstanding. The resulting monetary stimulus arrived just when slowing global growth made it most welcome; this is Germany’s version of the flight to quality that the US enjoys thanks to the dollar’s status. Countries that benefit from international monetary arrangements should be prepared to invest in preserving them.

[...] the Germans have it right: Europe’s currency union does indeed involve transfers. But it is not true that these transfers flow only one way. Germany pays out via bailouts and intra-regional transfers; but it also receives benefits via trade and monetary channels. If only Germany could accept this truth, it might yet muster the will to rescue the euro – and salvage a generation of efforts to build an integrated Europe.

Financial Times: Sharon Bowles, “Time for sovereigns to swallow their medicine“ – Just as structured investment products such as collateralised debt obligations were tainted post-Lehman, so too is sovereign debt. There are other parallels too – just as regulatory reliance on ratings contributed to sleeping on the job over complex products, so too have regulatory exemptions and zero risk weightings removed the brakes from the sovereign debt wagon.

Financial Times: Mohamed El-Erian: “Europe’s banks must be forced to recapitalise now“ – Given this week’s developments, there should be no doubt in anyone’s mind that what started out as a dislocation in the periphery of the eurozone has now decisively breached the firewalls protecting the outer core and is seriously threatening the inner core . . . In the eyes of the markets, the capital cushion of Europe’s banking system as a whole is no longer sufficient to support its balance sheet. This concern is not limited to the markets. Judging from their eagerness to dispose of assets, bank managements also believe that balance sheet delevering is key to the institutions’ survival and well being.

Lousy German bond auction:

Germany saw one of its poorest debt sales on Wednesday in what was seen as a failed auction by many market participants amid fears the eurozone’s debt crisis is spreading all the way to Berlin. Marc Ostwald, at Monument, said “I cannot recall a worse auction … If Germany can only manage this sort of participation, what hope for the rest. Yields are at completely the wrong level.” Mr Oswald said the bid-to-cover ratio was only 0.65 times as the German debt agency sold just €3.644bn of its new 10-year Bund of the €6bn targeted. The Bundesbank retained a massive €2.356bn, which it will plan to sell over the coming days in the hope market sentiment improves. If the Bundesbank retention is included, the bid-to-cover ratio was a modest 1.1 times. Many market participants consider this an auction failure although some say technically it is not, as by retaining its own bonds the Bundesbank has pushed the bid-to-cover ratio above 1.0 times. The average yield for the 10-year bonds was 1.98 per cent.

Lousy eurozone economic indicators:

Eurozone industry saw the biggest one month fall in orders in almost three years in September, as worries about the region’s escalating debt crisis hit demand. New orders plunged by 6.4 per cent compared with August, according to Eurostat, the European Union’s statistical office. It was the biggest month-on-month fall since December 2008, when the global economy was reeling from the collapse of Lehman Brothers investment bank. Then, orders dropped by 10.2 per cent.

The data suggested the region’s debt crisis had undermined economic confidence even more than feared, resulting in business and consumers cutting back investment and spending. Earlier this week, the European Commission reported its index of eurozone consumer confidence had fallen in November for the fifth consecutive month to the lowest level since August 2009.

With orders data providing an early indication of trends in economic activity, September’s figures added to evidence that the eurozone has fallen into recession. Italy, where the eurozone debt crisis intensified from August, saw the biggest drop in industrial orders – of 9.2 per cent – between August and September. But France and Spain saw drop of 6.2 per cent and 5.3 per cent respectively, and Germany saw a 4.4 per cent contraction in orders.

Eurozone purchasing managers’ indices for November, also published on Wednesday, indicated overall economic activity is contracting at a significant pace – although the rate of decline appeared to have stabilised. The “composite” index, covering manufacturing and services, rose from 46.5 in October to 47.2 – the third consecutive month below the 50 level, which divides an expansion in activity from a contraction.

Merkel says ECB mandate can’t be changed:

In a forceful speech to the Bundestag lower house of parliament, Chancellor Angela Merkel issued one of her starkest warnings yet against fiddling with the central bank’s strict inflation-fighting mandate . . . “The European currency union is based, and this was a precondition for the creation of the union, on a central bank that has sole responsibility for monetary policy. This is its mandate. It is pursuing this. And we all need to be very careful about criticizing the European Central Bank,” Merkel said. “I am firmly convinced that the mandate of the European Central Bank cannot, absolutely cannot, be changed.”

The European Commission has released the “Green Paper on the feasibility of introducing Stability Bonds,” the draft of which I included in one of my Monday posts.

• Press release
• Green Paper
• Consultation on Stability Bonds
  • Privacy Statement
  • Questionnaire

Merkel tells the EC to mind its own business:

German Chancellor Angela Merkel slapped down a new European Union push for bonds issued jointly by the 17 euro nations, saying Tuesday that they wouldn’t resolve the debt crisis and now is the wrong time to discuss them. Merkel dug in on her resistance to calls for an instant solution to the crisis hours after the EU’s top economic official tried to sell a skeptical Germany on Brussels’ new drive for so-called “eurobonds,” which the EU’s executive Commission is now calling “stability bonds.” Merkel has staunchly opposed anything resembling eurobonds, which the Commission’s head argues would be an effective way to avoid disaster as many countries’ borrowing costs spiral higher in the debt crisis.

The chancellor noted in a speech to Germany’s main employers’ association that so-called eurobonds “have just come very much back into fashion.” But she was unbending in her opposition to introducing them, saying that what’s important is to address shortcomings in the construction of the eurozone. “If at all, this discussion belongs at the end — so I don’t find it particularly fitting that we are now once again conducting it in the middle of the crisis, as if it were the answer to this crisis,” Merkel said. “In the long term, it isn’t.”

Merkel also underlined her resistance to mounting pressure for a major bond-buying campaign by the European Central Bank as a way of relieving pressure on other countries’ borrowing costs. She said of hopes of an immediate solution to the crisis: “I say yet again: there won’t be one.”

The EC Green Paper is one part of the EC’s “package enabling new action for growth, governance and stability” announced today:

• Press release
• The 2012 Annual Growth Survey: FAQ
• Economic Governance
• Speech by President Barroso
• Annual Growth Survey
  • Annex: Progress Report on the Europe 2020 Strategy
  • Annex: Macro-Economic Report
  • Annex: Draft Joint Employment Report
  • Annex: Growth Friendly Tax Policies
• Regulation on common provisions for monitoring and assessing draft budgetary plans and ensuring the correction of excessive deficit of the Member States in the euro area
• Regulation on the strengthening of economic and budgetary surveillance of Member States experiencing or threatened with serious difficulties with respect to their financial stability in the euro area

From the online Wall Street Journal at 11pm:

• EU Banks Struggle to Lure Deposits

Several large Italian and Spanish banks recently reported double-digit percentage declines in deposits from corporate and other institutional clients, although their overall deposit levels fell more modestly, as lenders hold a greater share of retail deposits. The deposit base at Spanish banks dropped by €48 billion ($64.8 billion), or 2%, in the third quarter, according to the Bank of Spain.

The deposit outflows come as emergency borrowings by banks from the European Central Bank soared to their highest level in more than two years Tuesday, with the ECB allotting €247.2 billion in seven-day funds to banks, a jump from the previous 2011 high of €230.3 billion.

Meanwhile, banks in countries like Spain, Portugal and Italy are scrambling to retain existing customers and attract new ones by dangling ever-higher interest rates on deposits, making it more expensive for banks to finance themselves affordably.

[...] To be sure, analysts say that overall, European banks still have hundreds of billions of euros of deposits, many of them from individual customers who tend to be reluctant to switch bank accounts. The lenders also can turn to financial lifelines from the European Central Bank, posting government bonds and other assets as collateral.

But if the drought continues, it could pose a threat. European banks face a wave of maturing debt next year—up to €800 billion, by some analyst estimates. If banks can’t replace those funds by selling bonds or gathering new deposits, they will need to compensate by cutting lending. The situation is worrying regulators, policy makers and investors. Some officials have called for European governments to band together to guarantee new long-term bank debt, but senior finance officials from European countries rejected the idea at a meeting last week, according to people familiar with the discussions.

[...] Deposit levels at five of Spain’s top six banks declined in the third quarter, while five of Italy’s largest lenders also reported declines, according to a report by analysts at Citigroup . . . Spain and Italy’s largest banks each reported declines of at least 10% in the quarter that ended Sept. 30.

With deposits simultaneously becoming scarcer and more valuable as a funding source, some banks are entering into a sort of arms race. They are jacking up the interest rates they are offering on deposits and venturing into other European countries in the hunt for new customers. Even though the ECB is keeping its key interest rate at the historically low level of 1.25%, banks in Portugal, Spain and Italy are routinely offering to pay customers more than 4% annually for deposits.

• Europe’s Smart Money Votes With Its Feet

In Italy, nonretail customers withdrew €56 billion in the three months to the end of September, a fall of 12%. Intesa Sanpaolo and UniCredit saw corporate deposits decline by 16% and 10%, respectively, according to Citigroup research. Similarly, in Spain, nonretail deposits fell by 20% in the third quarter, with Santander and BBVA losing 10% and 11%, respectively. Even the French banks weren’t immune: Société Générale and BNP Paribas saw their corporate-deposit balances fall by 7% and 6%, respectively.

[...] if the trend in deposits continues, it will add to the pressure on banks to deleverage. Euro-zone banks are likely to cut up to €2.5 trillion of assets, equivalent to 5% of their total assets, as they struggle to meet new regulatory rules, reckons Morgan Stanley. Much of this can likely be achieved by cutting international operations and investment-banking activities. But as banks try to pass on higher funding costs, lending to core domestic economies could suffer, worsening the debt crisis.

• Santander Raises Cash With  Chile Stake Sale

Banco Santander SA is preparing to sell a nearly 8% stake in its Chilean business, the latest in a string of moves in which the Spanish bank is raising concerns among investors.

The move in Chile comes as Santander, widely viewed by many investors and analysts as one of Europe’s strongest lenders, also has unveiled plans to sell 8% of its Brazilian unit; the deals could raise a total of about $3.5 billion. It also sold a slice of its U.S. auto-loan unit last month for about $1 billion and made a recent offer to exchange some of its outstanding bonds, raising about €600 million ($809 million). The goal is to strengthen the Spanish bank’s capital cushions.

The efforts highlight how Santander and other European banks are scrambling to raise capital without taking steps such as reducing dividend payments or selling new shares at distressed prices.

[...] the terms and timing of Santander’s moves are raising eyebrows in the investment community. Analysts have expressed surprise that the bank is selling chunks of two of its prized Latin American businesses. And the bank’s debt-exchange plan, intended to drum up less than €1 billion in fresh capital, is on such unfavorable terms that it prompted a group of British insurance companies that are some of the major holders of this debt to band together to complain.

• Big Selloff Hits Europe Bond Markets

The Spanish Treasury was forced to pay a euro-era record 5.11% yield on three-month Treasury bills at auction, more than double the rate paid at last month’s auction. By way of comparison, to access the short-term debt market Spain now must pay more than Greece paid at its last three-month auction a week ago.

[...] The spike in yields fanned fears that the country will find it unsustainable to raise funds in the market if the trend persists. The result underscored concerns that more financially weakened euro-zone governments may soon be priced out of the capital markets.

The cost of insuring European government debt against default using credit-default swaps shot up to record levels as concerns about the euro-zone debt crisis and U.S. deficit-reduction plans continue to spook market participants and subdue activity in the European primary bond market. Default insurance on French, Belgian and Spanish debt leapt above record closing levels Tuesday as bond yields in the region climbed.

French bond yields also spiked sharply in a sign that the debt crisis was continuing to spread to larger, top-rated countries. A continued rise in French bond yields would put the country’s coveted triple-A rating in peril and risk derailing efforts to contain tensions.

• EU Warns Greece on Bailout

The European Union has warned Greece that unless political leaders give written pledges they will back agreed reforms, an €8 billion ($10.79 billion) loan payment won’t be given and the country will run out of money in about 20 days, Greek and euro-zone officials said Tuesday.

• Pressure on Merkel Amplifies

Ms. Merkel on Tuesday stressed that joint debt issuance isn’t the right response now. “The discussion of euro bonds in the midst of the crisis is inappropriate,” she said.

Germany has never categorically ruled out the joint issuance of bonds by the euro’s 17 national governments, known as euro bonds. But Berlin insists that before euro members collectively raise financing on the open market, they must create rules that force each country to exercise fiscal discipline—or pay a heavy price.

However, many analysts say Ms. Merkel may no longer have the luxury of time to wait for euro-zone economies to heal before working on long-term changes Germany believes are needed to prevent such a crisis from recurring.

[...] Many lawmakers in Ms. Merkel’s ruling center-right coalition are deeply skeptical about joint euro-zone liability for debts, which they fear would reduce pressure for southern European countries to rein in government spending. “The moment we let up the pressure, those countries that have such problems will become complacent,” German Finance Minister Wolfgang Schäuble said Tuesday.

In addition to being a hard sell to Germany’s lawmakers and voters, euro bonds may require amending the country’s constitution, requiring a broad consensus among political parties in the euro zone’s biggest member.

This post is a veritable potpourri of worries. Be warned.

With the landslide victory of Mariano Rajoy’s center-right Popular party, the government of the Spanish Socialists has become the fifth victim (after Ireland, Portugal, Greece and Italy) of the eurozone crisis. As have the leaders of the other recently-installed governments, Mr. Rajoy has promised to enforce budgetary austerity.

No matter. Despite the Popular party’s victory, yields on Spanish sovereign debt rose today; the ten-year bond yield reached 6.6 percent. Yields on the sovereign debt of other “peripheral eurozone” countries also jumped, as did the yields on “core” countries debt.

Undoubtedly, a report from Nomura — “Currency risk in a Eurozone break-up — Legal Aspects” contributed to today’s indigestion in the eurozone bond markets. The report deals with a subject — “redomination risk” — that has evidently not previously been on market participants’ radar screens: not knowing which euros will stay euros.

It is now obvious that the widespread electoral success of parties committed to fiscal rectitude isn’t sufficient to ameliorate, much less bring to a halt, the crisis by improving investor confidence. That this has become self-evident further undermines confidence, as what was once thought to be a solution has turned out not to be. More than ever, all eyes are turned toward the European Central Bank, with the hope that the ECB will, at long last, overcome its reticence and become the eurozone’s lender of last resort. As yet, there’s no evidence whatsoever that the ECB will undertake what would be an about-face of epic proportions; last Friday, the ECB’s president said that the crisis required a political solution and that the ECB wouldn’t bailout anybody. This situation will persist unless and until Germany performs its about face. But that isn’t happening; if anything, the Germans are digging in their heels.

No wonder, then, that commentaries on the crisis are becoming increasingly strident and downright panicky.

Wolfgang Munchau, writing in the Financial Times, uses the words “insane” and “depression”:

The consensus view in Brussels and Berlin is that the crisis can be solved by technocratic governments imposing structural reform and austerity. That proposition is, in my view, insane . . . We have gone way beyond the point at which this crisis is solvable by standard instruments of economic policy. The survival of the euro will now depend on whether Ms Merkel or Mr Draghi, or both, will blink.

This may yet happen, but not right away. The ECB is facing more formidable legal constraints than those who call for an intervention acknowledge. The bank is technically allowed to engage in secondary bond market purchases, but not with the aim of helping governments incur deficits or roll over debt. Article 123 of the Treaty for the Functioning of the European Union says the ECB shall give no overdrafts to governments. Clearly, the euro was sold on the grounds that the ECB would never do what it is being asked to now. Such a law is testimony to a lack of realism, especially given what we know about the history of financial crises.

[...] The eurozone has already entered a recession, driven by three factors, each serious on its own and lethal in combination: a slowdown of the global economy; pro-cyclical fiscal austerity programmes; and a much larger than expected deleveraging of the financial sector. If present policy prevailed, the eurozone would be in danger of falling into a depression.

[...] In present market conditions, a leveraged EFSF is unrealistic. So how long can this policy vacuum be sustained? So far, the speed of the crisis has exceeded the speed of the political response. The next political turning point will come at the European Council meeting in December, which will need to decide something more substantial than previous summits.

If that does not happen, we will be getting closer to the point where member states – confronted with an unsustainable funding position – could rationally conclude that the political and financial costs of staying in the eurozone may well exceed the costs of an exit. This is not a proposition anybody would want to test. Once the eurozone goes down that road, it will not come out of this crisis in one piece.

The moment will arrive, probably sooner rather than later, when Mr Draghi and Ms Merkel will have to blink simultaneously. The odds of that happening are neither low nor high. They are indeterminate. It is the worst kind of uncertainty imaginable.

George Soros describes the current situation as “a perfect vicious circle”:

Bank “Tinkering”; EFSF Leveraging; Italy After Berlusconi

The Tinkering Banks

• “Fears rise over banks’ capital tinkering” – Concern is growing that banks in Europe and elsewhere are moving to meet new tougher capital requirements [under the Basel III rules] by tinkering with their internal models to make their holdings appear less risky.

. . . banks, faced with volatile markets and low share prices, are reluctant to issue equity right now. So many of them are instead trying to reach the required ratios by reducing the denominator, through what they call “risk-weighted asset optimisation”. In some cases, that means selling or running down risky assets, but in others, it means changing the way risk weights are calculated to cut the amount of capital that will be required.

The Regulators

Regulators, who must approve bank models, are alive to the problem and the European Banking Authority’s board has essentially set a floor on how low the risk weights can go when it comes to calculating the EU’s 9 per cent target.

Some of the optimisation is encouraged by the regulators. Banks effectively get an risk-weighted asset break when they switch from the old Basel I rules – which apply standardised risk weights to loans based on their category – to the “internal ratings based” system that is the basis for Basel II and III.

Under the internal ratings system, banks come up with models that predict the probability a particular loan will default and the likely loss if that occurs. The numbers are then plugged into a formula that assigns a risk weight. In general, using internal ratings produces somewhat lower risk weights – and therefore requires less capital – than the standardised approach because regulators want banks to build good models and improve risk management.

. . . there is a second kind of optimisation that regulators are more concerned about. When banks create models, regulators then back-test them and will only approve those that produce probabilities of default and predicted losses that are higher than real-life experience.

But the current recession has produced lower loan default rates than past downturns – partly because interest rates are low – so many bank models are currently producing results that are significantly more conservative than real life.

That creates room for banks to tweak their models, and some are doing so in a deliberate effort to cut their capital needs, industry participants say.

Germany

Commerzbank reported in its third-quarter results that it is getting new models approved in the wake its merger with Dresdner and should see benefits in its risk-weighted asset totals.

United Kingdom

A recent Morgan Stanley analysis of Lloyds Banking Group found the bank sharply reduced the risk weighting of its overseas retail mortgage portfolio in 2010, leading to a £16bn fall in risk-weighted assets. Lloyds’ optimisation programme is understood to include selling and running off assets and also getting the agreement of the UK regulator to change risk weights on various loans so less capital needs to be placed against them.

Spain

Santander has said that it is currently in the process of “optimising” its risk-weighted assets even as Alfredo Sáenz, its chief executive, hit out at “fudges outside of Spain”. Spain’s largest bank said it is focusing on the risk weighting of certain kinds of loans, such as unused lines of credit and loan commitments, as well as shrinking its balance sheet by writing off non-performing loans.

BBVA, Spain’s second-largest bank by assets, has been slowly switching to the internal ratings system since 2008 and last year got approval from the Bank of Spain for more modsels. For now, the regulator has established a floor for operational risk equal to the standardised approach, but the bank said it would expect that this floor could be removed in the coming months, which would lead to a drop in its overall risk-weighted assets.

Leveraging the European Financial Stability Facility (EFSF)

• “Expanding Bailout Fund Returns to Focus” — WSJ, no link.

Of chief concern to potential investors in bonds of troubled euro-zone countries is the extent to which the countries’ stronger peers will back them up. Many investors and analysts have called for a bailout fund with a capacity of a few trillion euros, or for a massive program of government-debt purchasing by the European Central Bank.

But despite months of debate, little progress has been made in assembling the larger bailout fund. And ECB officials have repeatedly made clear they don’t intend to embark on bond-buying on a massive scale.

The bailout fund has been particularly slow going. The €440 billion ($605 billion) fund has perhaps €250 billion to €300 billion remaining after its commitments to Ireland and Portugal and its expected commitment to Greece. European leaders have said they hope to leverage that sum to around €1 trillion, essentially by using it as the basis to attract outside capital.

Europe is in a quandary: The euro zone’s major players have insisted that they won’t put any more money into the fund themselves. But [the European Commission's] Mr. Regling’s comments suggest that outside investors won’t, either, until they know more precisely what their money might be used for.

That implies that Europe, paradoxically, might have to get even closer to a cataclysmic event before it knows just how big is its firewall against such an event.

• Wolfgang Munchau, “The only way to save the eurozone from collapse“

I am hearing from Berlin that the German government believes that the arrival of Mario Monti as Italian prime minister is all it will take to calm the markets. This unsurprisingly complacent view misjudges the underlying dynamic of the most recent events. The cause of the panic attack was the European Council’s decision on October 26 to renegotiate the private sector participation of Greek sovereign debt holders. With that decision European leaders destroyed what was left of a functioning eurozone government bond market. Investors interpreted it – correctly in my view – as a precedent. They then dumped their Portuguese, Spanish, Italian and even French government bonds. As of now, there is only one significant risk-free asset in the eurozone – German government bonds.

Actually, they need a very large Eurobond. We have moved beyond the “blue-bond, red-bond” proposal of the economists Jacques Delpla and Jakob von Weizsäcker (who last year proposed a clever scheme under which member states could issue new bonds under joint-and-several liability, but only up to an agreed limit and subject to certain rules).

What is now needed is something that affects not only new flows of debt, but also existing stocks. The German Council of Economic Advisors last week proposed an intelligent and ambitious scheme for what they call a “debt redemption fund”. Unfortunately, it suffers from the weakness that it is temporary. I am not sure that it is practical to launch a joint-and-several debt security as a pure crisis mechanism, and then to take it away a few years later.

The second reason you need a Eurobond is the effective collapse of the silly idea of leveraging the EFSF. Klaus Regling, the EFSF’s head, is wrong to say that market volatility has made it impossible to reach the leverage target. It was the other way round. The eurozone’s refusal to capitalise the EFSF properly contributed to the panic. A leveraged EFSF would have the worst kind of Eurobond: a tranche in a toxic debt security. I really hope EU leaders will come to their senses and stop pussyfooting with dubious financial instruments. The eurozone needs a risk-free asset class, and this means something boring and simple.

Of course, the EU cannot introduce a Eurobond overnight. The most its leaders can do is to issue a credible statement of intent, and set in motion a process to enact the legal changes needed. It will take time.

But once they make such a declaration, there should be no obstacle to endowing the EFSF with a banking licence. The EFSF could announce that it would make unlimited purchases of national sovereign bonds to keep their spreads under an agreed cap – say 2 per cent for 10-year bonds. The European Central Bank would refinance the EFSF for as long as it takes. Once the Eurobonds are in place, EFSF liabilities would simply be transformed into Eurobonds. This would not constitute an illegal monetisation of debt, as long as the endgame for the EFSF is credible.

The eurozone is thus without alternative. The introduction of a Eurobond will, in turn, require a broader and deeper economic government that extends well beyond the notion of a fiscal union. It would be more than a financial instrument. If it were to happen, it would catalyse further political integration.

But it might not happen. The crisis is moving too fast. We may well find that the Germans, the Dutch and the Finns are not ready for this. Their political leaders have certainly not prepared the ground for such a momentous decision. When the decision day comes, the day when the crisis reaches its bifurcation point, they might not be ready.

Unfortunately, we are now at, or very close, to that point.

Italy After Berlusconi

• Editorial, “Repairing Italy’s Broken Engine“
• Beppe Severgnini, “Italians want a comeback, not decline” –
• Gavyn Davies, “The Italian Job“
• “Berlusconi ‘ready to pull pulg’ on Monti“
• “Italy races to install Monti government“