The Second Wave of Europe’s Banking Crisis is Crystallizing

As the crisis in the European financial sector deepens, trading patterns are indicating a major sell-off within the next month, if the market breaks out of the consolidation pattern forming in the MSCI European Financials Index.  After all, the ECB’s extension of its liquidity safety net for vulnerable euro zone banks – and the guarantees for troubled banks in Ireland – can only fuel suspicion about skeletons in the closet.

It’s the growing realization that the weakest banks may only have been saved temporarily, by taking on even more risk, that’s leading investors to conclude that the European financial system may be even more unstable than it was at the start of the credit crunch.  And now the news flow – and rumors of a bank in trouble – are coinciding with the formation of a big technical ‘flag’ pattern for the sector that points to a sharp sell-off.  As can be seen in the chart ishares’ Spanish ETF is tracking the financials sector – given that 45% of it is invested in banks.

Evidence of the fraud against investors and European taxpayers by banks that didn’t provide as comprehensive a picture of their government-debt holdings as regulators claimed, is slowly coming to light.  Only yesterday, ECB Governing Council member Guy Quaden agreed that the markets did not yet have complete and immediate information on the state of financial institutions; and said that conditions in the financial sector still haven’t “normalised.”

Euphoria that Europe has put the financial crisis behind it is premature, therefore.  Having been hoodwinked, the markets’ focus will now be on discovering true state of European banks’ balance sheets, and the banking sector’s ability to refinance its existing debt this autumn.

The ability of the weakest financial institutions to fund themselves will be challenging.  New capital ratios being negotiated by the Basel Committee this week, will reportedly be higher than originally expected, with the minimum Tier 1 capital ratio being raised to 9%, from 4%– forcing banks to seek even more funding.

To make matters worse the ECB seems to be just as culpable of the irresponsible behaviour that European trade commissioner Michel Barnier accuses the banks of.  By shoring up lenders with cheap access to short-term funding, the ECB increased moral hazard.  On top of that Europe’s banks were allowed to use riskier long dated sovereign bonds as collateral for low interest loans.  No wonder then, that their exposure to Greece, Ireland, Portugal and Spain increased by 4.3% in the first quarter of 2010, taking the total exposure to $2.6 trillion – compared to US banks’ $5.4 billion.

The ECB has tightened its criteria for the collateral it accepts, and now imposes haircuts of up to 29% on government debt used as collateral; so banks can no longer borrow at the full face value of the bonds.  Unfortunately, that policy is reducing the incentive for banks to buy riskier debt just when the least creditworthy members of the euro zone desperately need to find buyers for their debt.

This sovereign “carry trade” will prove to be a fatal misjudgement that will eventually bring down some of the biggest banks in Europe – as Germany’s taxpayers will not ultimately sign a blank cheque. “To put it bluntly,” says the BIS, “the combination of remaining vulnerabilities in the financial system and the side effects of such a long period of intensive care threaten to send the patient into relapse.”