A lot has happened since my last posting on the June 23rd Brexit vote. A new government in the UK, the petition for a new referendum vote has been exposed as a scam, most markets have stabilized as anticipated and the Labour Party civil war over its leader’s leadership—or lack thereof, depending on your point of view—is deepening.
Yet the interesting developments are overseas. The one that immediately matters is the reaction of European banks’ share prices, which fell sharply. The focus immediately switched to Italy: Italian banks’ share prices had fallen 20 to 25% in just two days. Monte dei Paschi, the world’s oldest bank, and Unicredit, Italy’s biggest bank, looked to be on their last legs, and it was reckoned that Italian banks had more than €360 billion in bad loans, four times what they were in 2008, a quarter of the Italian GDP. Even before the Brexit vote, the Italian government had already proposed yet another taxpayer-financed bailout of its banking system.
Slight problem, and it’s not the one you might first think of. A taxpayer bailout might be viewed as a bad idea? Nope. A taxpayer bailout would overload Italian public finances, which are already in dire straits with a public debt-to-GDP ratio of over 130%, the highest in the EU after Greece? Nope. Not having a taxpayer bailout of the Italian banks would provoke a run on the Italian banking system and possibly a run on the entire European banking system? Nope.
The problem is that the EU Banking Directive that recently came into force does not allow taxpayer-financed bank bailouts. The Italian proposal was flatly vetoed by the Germans. “We [just] worked to set down certain rules about bank resolution and bank recapitalization,” Mrs. Merkel explained. “We can’t do everything again every two years. We put a lot of effort into that.”
Whether such a bailout of the Italian banks is a good idea or not is moot. It is verboten.
But silly me: I am assuming that the EU follows its own rules!
Just because something is prohibited under EU rules does not mean that the EU will not allow it. Think of the Stability and Growth Pact (SGP): government deficits to be capped at 3% of GDP and government debt at 60% of GDP. The SGP is binding, we are assured, but not a single major EU government actually meets these requirements and no pressure or sanctions are applied to compel compliance. Ho, ho, ho!
As I have long maintained, the EU has rules, but they only apply on paper. Whenever they threaten to constrain some favored policy option—that is to say, to do something policymakers shouldn’t do, after all the rules are there for a reason—then the rules are ignored. The EU rulebook is Monty Python’s cheese shop: the best one around and uncontaminated by any cheese.
Nor should we not forget the EU’s track record on referenda: it is OK to allow the plebs to decide, but only if they decide the way they supposed to, i.e., by endorsing greater powers for the EU itself. If the riff-raff don’t like this agenda, so what? We will keep putting the question to them again and again—with a few minor, ancillary promises that we will ditch at the first available opportunity—to obtain their approval for what we are going to do anyway. This arrangement was working just fine till it was torpedoed by the Brexit vote. The peasants are in open revolt, the Brits first and then their continental colleagues—and this time there will be no stopping them. More on this in my next posting.
A curious perspective on the bailout issue was provided by David Folkerts-Landau, the chief economist at Deutsche Bank. On July 11th, he told Welt Am Sontag that European banks should be given a €150 billion bailout to help them recapitalize. He also argued that the situation in Italy was so urgent that the bail-in rules of the Banking Directive should be thrown aside, i.e., that taxpayers should pay for the bail-out, not bank investors, as otherwise there would be major runs. Basically, Brexit-Beleaguered Banksters Back to Begging for Bailouts.
Well, let’s leave aside a few inconvenient home truths: that taxpayers had not consented to underwrite these risks and been stiffed before big-time in the Global Financial Crisis; that bank investors had not only freely chosen to bear these risks, and in taking them were openly gambling on being bailed out by the taxpayers, whom they regarded as suckers; that we had been promised cross-my-heart-hope-to-die that there would be no more bailouts; that EU rules now prohibit bailouts; that we were repeatedly reassured that the banking system had been fixed so bailouts would be unnecessary anyway; and that another round of bailouts would trigger a big backlash against banksters and their backers, most notably the EU itself.
Instead, let me merely observe that it is odd that no-one seems to have thought of these problems before and that Mr. Folkerts-Landau omitted to explain why it was okay to apply these rules to Cyprus and Greece, but not to larger countries such as Italy or—dare one even say it—Germany.
Perhaps the Germans should look at the beam in their eye and not at the moat in their Italian brothers’ eye. As the Italian Prime Minister Matteo Renzi angrily retorted to the German veto: “If this [Italian] non-performing loans problem is worth one, the question of derivatives at other banks, at big banks, is worth one hundred. This is the ratio: one to one hundred.” The difficulties facing Italian banks over their bad loans are miniscule compared to the problems some other banks face.
As an entertaining aside, why would one EU leader be so keen to highlight major problems in the banking system of another, which could weaken public confidence in the European banking system and then rebound back on him by bringing down the whole house of cards? Answer: because he is playing to the domestic gallery and his back is against the wall. If he gives in to German demands, he would face losing face for not standing up to foreign interference and be unable to prevent the collapse of the Italian banking system. He would soon be booted out and the Euroskeptic Five Star movement would be in power. So Mr. Renzi is cornered with only one way out. In any case, Italian policymakers have never had a British or German-style complex that rules should actually be followed. I just cannot see Mr. Renzi going down in flames in deference to German insistence that he follow rules that prevent him from doing what he thinks he needs to do in his own country’s national interest. He has made this clear, too: he “will not be lectured by the schoolteacher,” he said. “We are willing to do whatever is necessary [to defend the banks],” and he did not rule out acting unilaterally if he had to.
Instead I think Mr. Renzi is playing poker or rather MAD—Mutually Assured Destruction—with his German counterparts: if they don’t relent, he is prepared to expose their dirty laundry; the collapse of Italy’s banking system will assure the collapse of the German one too. How very communautaire.
But returning to my main storyline, whoever could he have been referring to?
That’s an easy one. It has been an open secret for years that the biggest banking problems in Europe are not in the fringe countries or even in Italy; instead, they are right at its heart, i.e., in the French and German banking systems. The biggest problem of all is with Europe’s biggest bank, Deutsche, the most systemically dangerous bank in the world. In 2013, FDIC Vice Chairman Thomas F. Hoenig famously lambasted Deutsche: “It’s horrible. I mean they’re horribly undercapitalized. They have no margin of error,” he said. There have also been a string of problems with Deutsche’s risk management and regulatory reporting over the years: for example, in late 2013 the New York Fed warned that Deutsche’s US arm—which doubtless reflects the bank worldwide—was suffering from a litany of serious problems that amounted to a “systemic breakdown” in its risk management and risk reporting. Deutsche has also repeatedly failed the Fed’s stress tests—the Fed’s annual Comprehensive Capital Analysis and Review—which have highlighted major weaknesses in the bank.
The key number is the bank’s leverage ratio, loosely speaking, its risk cushion, the ratio of its core capital to the total amount “at risk.” Under the Basel III capital rules, the absolute minimum leverage ratio is 3% although many experts suggest that banks should maintain ratios of at least 15%. Fast forward to Deutsche’s 2015 Annual Report and Deutsche reports a leverage ratio of 3.5%. Its co-CEO John Cryan called the bank’s balance sheet “rock solid” and pointed to its “strong capital and risk position.” He forgot to mention, however, that by the leverage ratio measure, Deutsche is weaker than every single one of its main competitors. Deutsche’s leverage ratio is no more than half that of the bigger US banks and Deutsche would not meet the new minimum leverage ratios soon to come into force in the United States: 5% for the 8 US Globally Systemically Important Bank holding companies and 6% for their federally insured subsidiaries. I am fairly sure that few outside Deutsche would suggest that a 3.5% leverage ratio is indicative of a strong capital position, but perhaps Mr. Cryan has a different understanding of the term “rock solid” than the rest of us.
Nor should the 3.5% number go unchallenged. The numerator (Tier 1 capital) is too large due to the inclusion of soft capital instruments and the denominator (a measure known as the Leverage Exposure) is too low as it omits a great deal of off-balance-sheets risks. If we replace these by Common Equity Tier 1 capital and Total Assets respectively—which are better measures though still flawed—then Deutsche’s leverage ratio falls to 2.71%, comfortably below the Basel III absolute minimum. However, for reasons I go into in the second edition of No Stress: The Flaws in the Bank of England’s Stress Testing Programme—which will be published later next week by the Adam Smith Institute in London—even this measure of the leverage ratio is biased upwards, i.e., all we know is that the “true” leverage ratio is less than 2.71% and possibly a lot less. In any case, even if we accepted the 2.71% figure as accurate, this figure is only the book value estimate. One can then argue that a better estimate would be the market-value leverage ratio as this ratio reflects the stock market’s perceptions of the strength of its balance sheet. It turns out that Deutsche’s stock price has fallen from a peak of $152.28 on 11 May 2007 to yesterday’s close of $14.56, which implies that the current ratio of its market to book value is only 25.5%. These numbers imply that the market-based leverage ratio is only just above 0.69%, i.e., that a loss of just over 0.69% would wipe out its core capital and render the bank insolvent. Such a leverage ratio is less than a quarter of Basel III’s absolute minimum. Or, to offer a different perspective, the world’s riskiest and most dangerous bank has a market cap well below that of Airbnb.
The size of Deutsche’s derivatives book—over €41.9 trillion or $46.2 trillion, roughly four times Eurozone GDP—is a bit of a concern too.
There is no polite way to put it: Deutsche ist kaputt.
If Deutsche were to fail—and many commentators are warning that it could fail very soon—a question arises: would the German/ECB/EU authorities take the advice they insist Italy take and allow the Bank to fail or would they bail it out instead? If the German/ECB/EU authorities are not burning the midnight oil on this question above all others, then they damn well should be. The immediately pressing problem is how to prevent a collapse of the Italian system from dragging Deutsche and the other big, weak European banks down, i.e., how to avert the impending collapse of the entire European banking system.
The European banking system is thus more than a little vulnerable and it cannot be taken for granted that any European policymakers have the slightest idea what they are doing. It’s “a highly volatile macro environment,” Folkerts-Landau had said in a Bloomberg Television interview on July 6. “All you need is one additional shock—and we’ve got three or four lined up: French elections, the Italian senate referendum—and you could have a very serious situation on your hands.”
He has a point, and I could add a few more risk factors to his list—the migrant crisis, the ongoing Greece debt/bailout saga, forthcoming referenda in Austria and Hungary as well as those in France and Italy, the Chinese, junk bond and government bond bubbles, conflict in the Mideast, a dangerous stand-off with Russia and, going back to the EU, a wave of anti-establishment discontent, a broken banking system and—the risk factor that should have been top of his list—the parlous state of his employer.
Don’t even begin to pin these problems on the Brexit. Some of us have been warning for years that the European banking system was not fixed. Instead of addressing these problems, the response of the policy establishment was a raft of extend-and-pretend policies to sweep them under the carpet for someone else to sort out later when they had become much more difficult to resolve. The banking system was now much improved, the ECB assured us; the Bank of England went further and assured us that the banking system is essentially fixed. Both also maintained that the banks are again well-capitalized and that the stress tests prove that European banks are robust. All such claims are demonstrable hogwash: see here, here, here, here and here. Real Eurozone GDP has barely moved since 2008, unemployment in a number of EU countries is over 20% and sometimes over double that for young people. The European banking system has a huge overhang of bad debts and the failure to address these banking problems—along with the failure to address shoddy governmental finances, another can kicked down the road—is why so much of the EU is in an economic depression with no end in sight.
It will now get a whole lot worse as the banking crisis reignites with a vengeance.
The interesting question is what happens next. On this subject, I would venture to offer a safe prediction: the banks will be bailed out and bank investors will not be bailed in because anything else would be fatal to the Eurozone, the euro and the European economy. Not to rescue the banks would see the banking system collapse. To bail-in investors would see them run and then the banking system would collapse. Whatever it takes.
You might say that that would merely kick the can down the road and I would agree, but on the other hand, if they don’t kick the can down the road there won’t be much more can to kick. The Keynesian Eurocratic policy establishment have painted themselves into a real tight corner this time.
They can’t say they weren’t warned.
 Update: after most of his shadow cabinet resigned and his parliamentary colleagues passed an unprecedented 172 to 40 vote of no confidence in him, Comrade Corbyn is now facing a formal leadership challenge and refuses to resign. He cannot even muster the support of enough MPs to get a place on the leadership candidates’ list, but now claims he doesn’t need to and is consulting m’ learned friends. He is gambling that the party membership will re-elect him as leader, even if the Parliamentary Labour Party refuses to follow his lead, which would then render Her Majesty’s Most Loyal Opposition even less effective in Parliament than it already is. Many Party loyalists are openly saying that if he stays, they will go and found a new Labour Party of their own.
 One might ask why the Brexit vote should have triggered a major fall in European banks’ share prices. FWIW, my conjecture is that the markets interpreted the result as an unexpected vote of no confidence in the EU (which it clearly was) that then translated into a dent in confidence in the EU/ECB policies that were propping up the European banking system.
 As Chris Whalen observes, while the official statistics are bad enough, “the reality may be far worse, in part because international accounting rules allow banks and governments to indefinitely delay recognition of non-performing assets. Significantly, for debt investors, timelines for the resolution of bad loans in the EU can extend out years, even decades, and are driven by government-appointed administrators that frequently take a pro-debt position in restructuring.” Put differently, the restructuring could take almost forever and still be far from enough.
 Under the new EU rules, the only permitted rescue of the banks is to ‘bail-in’ bank investors (especially bondholders), that is to say, to impose losses on them. Italian retail investors are said to have €187 billion in bail-in-able bonds and stand to lose the lot. Now leaving aside whether a bail-in would be sufficient, there is little question that it would be political suicide for Mr. Renzi. Last year more than 100,000 investors “widows and orphans,” etc.) in four small Italian banks saw their investments wiped out and there was a major public outcry. Mr. Renzi will not wish to go through all that again and on a much bigger scale.
 These derivatives numbers need to be taken with a big pinch of salt, however. One reason is that many of these positions will be (partially, at least) hedged; another is that in many derivatives contracts the notional principal (which the size of the derivative book partially reflects) is meaningless as a measure of risk exposure. Nonetheless, it is still the case that there is an enormous off-balance-sheet exposure and we cannot safely assume that the hedge assumptions on which the much smaller net exposures are based will hold in a crisis. In fact, we can safely assume that they won’t. There is a big problem here.