Jens Weidmann, president of Deutsche Bundesbank, recently wrote a terrific piece in the Financial Times, making the point that the Faustian bargain between European sovereigns, their national banks, the ECB and EU policymakers to encourage European banks to gorge on sovereign debt may be politically attractive in the short run while being fundamentally a horrible idea. With a wink and nod, President Draghi of the ECB essentially told the world that the ECB would keep the European banks afloat. With that assurance in their pocket, and the gnomes of Basel III declaring sovereign debt riskless, requiring essentially no capital, the banks continue to buy their sovereign debt – and buy big. By doing so, the banks become enablers of bad fiscal policy, artificially lowering the risk premia on all risk assets (resulting in mispricing), and clogging their balance sheets with government IOUs. The result: The banks are less able to support the real economy.
Bad economics. Ultimately, bad politics, because there is no easy unwind, and notwithstanding protestations to the contrary, it cannot go on forever.
Opportunities abound around any misguided policy (and this is no exception). U.S. banks and other non-bank lenders will find attractive lending opportunities in the European market for years to come. The domestic banks are simply not going to be able to meet domestic demand for capital formation for the foreseeable future, and international bank and shadow bank concern will step up to the opportunity. And maybe, as all of this has a tendency to depress European GDP, troubled loans on the banks’ balance sheets are simply not getting much better. That increasingly makes kicking the can down the road an exercise in futility. This, coupled with unlimited liquidity support and fat capital ratios delivered by the piles of "riskless" sovereign debt on the balance sheets, means that the banks may finally decide to accelerate the process of disintermediation and rid themselves of all those pesky real risk assets (like commercial real estate loans with real credit exposure) and just settle back to enjoy all that lovely sovereign debt.
Bad for Europe. But probably good for the U.S. and its lending community – there’s a pony in there somewhere.
By: Rick Jones