This chart is one more additional chart which shows how EU banks are cheating the market. In Dec 98 the ratio of total assets to risk weighted assets was 2:1. Which means that if their capital adequacy was 6% of risk weighted assets it was 3% for total assets.
Today the ratio of total assets to risk weighted assets is at 4:1 which means that if their capital adequacy is 6% of risk weighted assets, it is only 1.5 % for total assets. Coupled with Bank size with are 2 -4X GDP compared to 1X, for US, loan to deposit ratio which is more than 100% and their high leverage almost 25 -40X, means that most of the European banking system is today insolvent.
Total assets holds by EU banks are estimated to be 40 trillion dollar. While the total capital is only 2 trillion which means that they have a total Assets to equity of 20X. A mere 4 % loss on their balance sheet will wipe out their capital and make these banks insolvent. Moreover the GDP of Euro zone is 19 trillion which means that Bank assets to GDP are around 2X. On top of that Government debt to GDP is around 85%
If the National government recapitalize bank then their own Debt to GDP ratio will shoot up. Moreover no one is willing to give loans to PIIGS (and unlike US they can’t print their currency to recapitalize their banks) therefore they won’t be able to raise money to recapitalize their banks. Other countries like France will join group PIIGS as the cost of recapitalizing their banks which will push their Debt to GDP above 100.
This means that even if 10% of European assets go bad the Government will have to raise 4 trillion Euro to recapitalize banks which will bring their Debt to GDP levels at more than 100%. For countries like Italy who have debt of 1.8 trillion and GDP of 1.3n trillion this is simply not possible to recapitalize their banks which means that lot of banks will fail.
We have already seen that all banks are deeply inter woven with each other and if one bank fails it will create a domino impact. The market has realized this. If Italy 10 year bond yield move above 6% than it will give us an indication that the end game has began.
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| 10 Year Govt debt yield - Italy |
Things can definitely be very different form the dire circumstances I have predicted. They can choose to monetize their debt collectively and take some hair cut by restructuring their banks. Ultimately no one will benefit from this fall out and Germany and France are the one who will suffer the most.
Therefore they all want to find a solution out of this. The problem is that EU is a group of 27 countries and they need to approve any change in EU treaty by unanimous consent, which is difficult to obtain in such short time frame. The problem again is that will they be able to have a unanimous consent to initiate strong measures in short time and keep their domestic audience also under check. Looking at the current agitation in US “occupy the wall street” which has now spread to EU it seems very difficult for Government to bail out their banks and still win votes. For a politician his top most priority is to retain power.
If they bail out banks then they will lose power and if they don’t the economy will go in tailspin and they will lose power. So it’s a very ugly choice for them. They are all playing the game where they get the maximum benefits by paying the lowest price. France wants EU to recapatlize all falling banks so that its own debt to GDP don’t go up while Germany wants individual nations to bail out their own banks so it don’t have to foot the bill of bailing out French banks. Other small countries don’t want to take part in bailout as they think they will unnecessary take the debt burden.
People are hoping that things will work out perfectly well but it never dose. Look at 2008 every time there was FED or Government announcement people thought that the worst is over but things kept on deteriorating. Similarly today in Europe we will see Government making big announcement but little action will be taken. There is so much uncertainty in Europe that something will give away. I will give 70% probability that things will go in a tailspin and 30% that this crisis will be managed well. Therefore I believe it is imperative that investors should get out of risky assets and stay protected in cash or short term debt.
On the ending note I want to mention that today’s banking has become worse than hedge funds. Hedge funds make speculative leveraged bets and take 20% of the profits they make while 80% is given to investor for bearing risk. Banks make speculative leveraged bets and take 90% of after tax profits as Salaries and Bonuses and gives 10% to equity investor for bearing risk. And when these banks blow up tax payer will have to pay the bill for the mistakes they made. This situation is untenable and the current banking system needs to be changed.
