Those looking for the next unexpected crisis likely to derail global markets habitually cast their eyes toward the Eurozone, and in particular speculate about the vulnerability of its banking system.
But there are several reasons to think that, in the absence of definitive political revolt from Southern Europe, now is not the time that the cracks in the Eurozone’s architecture will actually bring the house down. Private sector cashflows are sharply positive, resulting in a positive flow of cash into Europe’s banks. That means those banks need not worry too immediately about deteriorating asset quality. What is more, the combination of seriously dampened leverage and a build-up of bank capital provides greatly improved protection against the impact of bad assets.
As a result, real economic factors are unlikely to topple the Eurozone’s banks any time soon. The lesson of the the 2008/09 collapse, however, is that threats to financial system stability usually comes from the sudden realization of excessive inter-bank financial leverage. But here too the signs are encouraging. Money is still flowing into Germany’s banking system in order to escape the risks of other Eurozone banking systems, but for now that flow is only moderate, and seems both stable and predictable. And in the wider global context, the recovery of volumes in derivatives markets (interest rate swaps, credit default swaps), also suggest confidence is, ever so slightly, gaining.
Cashflows: Taken as a whole, Eurozone’s private cashflows remain sharply positive. In the 12m to March 2016, the Eurozone ran a private sector savings surplus equivalent to 5.2% of GDP; by 2Q, this had probably risen to 5.3%, or roughly Eu560bn. In turn, we should expect this to result in a net flow of private deposits into the Eurozone financial system. Looking at banks alone, this continues to happen: in the 12m to June, private sector deposits grew by Eu359bn whilst loans to the private sector grew only Eu38bn – a net gain of Eu321bn which left the private sector with net deposits of Eu1.035tr. Provided banks experience an uninterrupted inflow of cash, they are unlikely to have to discover the true extent of their underperforming assets.
Bank Leverage: In these circumstances, it is unlikely that an existential threat to the Eurozone banking system will stem from problems in the real economy. Nevertheless, consider for one moment the most extreme possible scenario, in which all – yes, all – private sector loans turn sour, with not capital repaid, whilst all other assets (primarily government bonds, and foreign assets) proved illiquid. What proportion of deposits could one expect to be returned? There are two components to this calculation: first, the proportion of private sector loans to private sector deposits; and second, the proportion of bank capital and reserves to private sector deposits. The first of these elements is simply the private sector loan/deposit ratio, which has fallen from 114.1% at the beginning of 2008 to 91.3% today. The second element is the proportion of bank reserves & capital to private sector deposits: since 2008, bank reserves & capital have risen by 74.5% to Eu2.663tr, whilst private sector deposits have risen by 31.3% to Eu11.98tr, and the ratio has risen from 16.9% to 22.5%.
The result of the changes in these two ratios is that in the event of all private sector loans going sour, and with no sale of other assets, the remaining net deposits and bank reserves would allow a repayment of 31.2% of private deposits, up from just 2.8% at the beginning of 2008. This is, of course, a completely unrealistic catastrophe scenario beyond the wildest hallucinations of the world’s biggest bear. But if it suggests anything, it is that the vulnerability of the Eurozone’s banking system is not to ex-financial system commercial risk, but rather to a straightforward collapse in financial confidence and/or an explosion of risk within the financial system itself (as in 2008).
Flight From Risk: It is not easy to measure these risks. However, consider two indicators, one domestic within the Eurozone, and the other global. The domestic indicator is the extent to which the surplus cashflow entering the Eurozone financial system decides to flee the risks perceived in the Eurozone’s weaker peripheral banking system (for example Italy) for a perceived safer home in Germany. One can track the momentum of this trend in the movements of the Bundesbank’s Target 2 assets (which are, in effect, the net liabilities of the rest of the Eurozone banking system to the German banking system). As the chart below shows, these rose by Eu118bn in the 12m to July, to Eu660bn, and have been growing steadily at a rate of around Eu10bn a month since the middle of 2014. Crucially, however, there has been no repetition of the dramatic growth seen accompanying the capital flight from Italy/Spain etc in 2011/12, but rather a sustained but and predictable, and therefore manageable, drift.
International Liquidity Conditions: Moreover, the global background against which this drift is occurring is, for the time being at least, relatively benign. One of the ways of tracking shifts in not just global financial system liquidity, but more importantly, the tolerance the financial system has of its own leverage risk, is changes in the volume of derivatives trading. Using the International Swap Dealers Assn weekly data, two things are clear. First, by the beginning of August, the notional value of interest rate swaps was rising in yoy terms for the first time since March 2015. Second, the notional amount of credit default swaps outstanding had been sustained above trend uninterruptedly since March 2016, after diving in concert with global capital flows in the wake of the dollar’s rise in 2Q14. This recovery in swaps market activity is modest but persistent, and is sends the same message of stabilized capital flows and stabilized tolerance of global financial system risk as is found in Asia’s stabilized foreign reserves totals.
None of this is to suggest that the architecture of the Eurozone is anything other than disastrous. But if that that that architecture can be improved only under the most urgent financial duress, it looks likely to be unreformed any time soon.