The euro banking sector is huge: In April 2018, its total balance sheet
amounted to 30.9 trillion euro, accounting for 268 per cent of gross domestic
product (GDP) in the euro area. Unfortunately, however, many euro banks are
in lousy shape. They suffer from low profitability and carry an estimated
total bad loan exposure of around 759 billion euro, which accounts for roughly
30 per cent of their equity capital.
Share price developments suggest that investors have lost quite some
confidence in the viability of euro banks’ businesses: While US bank stocks
are up 24 per cent since the beginning of 2006, the index for euro-area bank
stocks is still down by around 70 per cent. Perhaps most notably, ’Germany’s
two largest banks, Deutsche Bank and Commerzbank, have lost 85 and 94 per
cent, respectively, of their market capitalization.
With a balance sheet of close to 1.5 trillion euro in March 2018, Deutsche
Bank accounted for around 45 per cent of German GDP. In international
comparison, this an enormous, downright frightening dimension. It is mostly
the result of the bank still having an extensive (though not profitable)
footprint in the international investment banking business. The bank has
already started reducing its balance sheet, though.
Beware of big banks — this is what we could learn from the latest
financial and economic crises 2008/2009. Big banks have the potential to take
an entire economy hostage: When they get into trouble, they can drag
everything down with them, especially the innocent bystanders – taxpayers
and, if and when the central banks decide to bail them out, those holding
fiat money and fixed income securities denominated in fiat money.
Banking Risks
For this reason, it makes sense to remind ourselves of the fundamental
risks of banking – namely liquidity risk and solvency risk
–, for if and when these risks materialise, monetary policy-makers can be
expected to resort to inflationary actions. In fact, to fend off these risks
from materialising, central banks have committed themselves to pursuing
chronically inflationary policies.
Liquidity risk describes the risk that a bank might fail to meet
its credit obligations in full. This is an inherent risk as most banks extend
long-term loans and refinance themselves with short-term funds. As a result,
they have to succeed in rolling-over maturing debt. In a situation in which
investors are no longer willing to lend their money, the banks may not be
able to obtain new funds and become illiquid.
However, in today’s fiat money system, central banks are in a position to
print up any amount of base money at any given time, and they can lend this
newly created money to ailing banks at their discretion. As a result, the
liquidity risk can be, and actually is taken care of by central banks. A
single bank may go under due to a lack of liquidity. But not the banking
system as a whole, as in a liquidity crisis, central banks can, and do,
decide to prop up the system.
Solvency risk means the risk that banks’ assets are not worth
enough to service banks’ debts. It can strike if and when losses on loans
make a bank’s incoming cash flow drop below its cash outflows. A bank may
well continue to operate for quite a while despite being insolvent: It meets
its daily payment requirements because cash outflows remain below the total
that will become due at some point in time.
Keep the Fiat Money System Going
If and when insolvency makes liabilities exceed its assets, however, a
bank’s equity capital is wiped out, and the bank may even default on its
debt, and savers and investors lose their funds. While it is relatively easy
for a central bank to prevent a liquidity crisis in the banking sector, it is
quite another matter when it comes to an insolvency crisis: Once asset values
start falling and losses are getting realized, problems reach a new
dimension.
If banks in such a situation fail to raise new equity capital, the
government – fearing a collapse of the banking system – typically steps in.
It either uses taxpayers’ money to provide banks with new equity capital, or
it can issue new debt, which is bought by the central bank against issuing
newly created base money, with the latter being paid in as new bank equity
capital – and the affected banks being taken over by the government.
In reality, central banks and governments have put a ‘safety net’ under
the banking industry. Smaller banks may well go under, but a scenario in
which the entire banking system goes belly up will be prevented for a simple
reason: Politically speaking, the costs of a fiat money system collapse is
simply too high and has to be prevented; no price is viewed as too costly to
keep the fiat money system going.
A Vicious Circle
This is what sets a truly vicious circle into motion. For today’s fiat
money causes booms which sooner or later must turn into a bust. The liquidity
risk and especially the insolvency risk can be expected to hit the banking
industry at some point. To prevent it from materializing, the central bank
must keep expanding the quantity of (base) money and keep interest rates at
artificially low levels, keeping the inflationary scheme going.
Central banks sow the seeds of crisis, and once the crisis unfolds,
especially when it affects banks negatively, central banks run bailouts by
injecting new money provided at artificially low interest rates, and the
vicious cycle starts all over again. Needless to say that such a cycle causes
economic and social problems on a grand scale. It makes the purchasing power
of money drop. Only a few benefit, while the majority of the people is taken
advantage of.
Given the problems of the euro area banking industry, we should indeed
wonder what might happen next. The scenario that the euro area economies
might grow out of their banking problems would undoubtedly be a rather
convenient one, but it is fairly unlikely. Bailing out ailing banks with
taxpayers’ money and an inflation-financed recapitalization of banks’ equity
capital might be a much less pleasant scenario, but it appears to be more
likely.
For one thing is indisputable: If an oversized banking apparatus starts to
shrink, the outstanding stock of credit and money will decline. And as the
quantity of money goes down, prices across the board trend downwards causing
deflation. Needless to say that deflation is a nightmare for highly indebted
economies: Falling prices increase the real debt burden, sending the
financial and economic system into a cataclysmic downward spiral.
Inflation Is a Policy that Cannot Last
The current president of the European Central Bank (ECB), Mario Draghi,
said in July 2012: “[T]he ECB is ready to do whatever it takes to preserve
the euro. And believe me, it will be enough.” Taken at face value, these
words suggest what the ECB is ready to do: to print up ever greater
quantities of euro balances to prevent the euro currency from falling apart.
Ironically, however, this is precisely what the ECB’s money printing scheme
will bring about.
Ludwig von Mises (1881 – 1973) noted in this context wisely: “All
governments are firmly committed to the policy of low interest rates, credit
expansion, and inflation. When the unavoidable aftermath of these short-term
policies comes to pass, they know only of one remedy — to continue their
inflationary ventures.” These words capture pretty well what has been
going on in the euro area.
Without the ECB’s overly generous issuing of fresh fiat money, the euro
banking apparatus could not have reached its current size, its bloated
dimension. And with its attempt to rectify its inflationary policies of the past
– namely preventing the euro banking sector from collapsing, the ECB is
about to pursue even more extensive inflationary policies. This doesn’t bode
well for the euro’s purchasing power going forward.
The euro area provides a textbook example of a rather unholy alliance
between the central bank and commercial banks: It has not only caused an
inflationary boom and bust cycle that has resulted in a severe financial and
economic crisis. The unholy alliance has also made possible an oversized (and
poorly performing) banking industry, and the policy to keep it going will
result in a rip off of the majority of the people on a truly grand scale.
