Is The Other Shoe Dropping in Europe?

Most of the American blogosphere's discussion of the ongoing crisis in the euro zone has concerned the governments: their budget balances, their interest rates, their prospects for economic growth.  That discussion maps rather neatly onto our own political concerns.

But as people like Tyler Cowen have been saying, the governments are only part of the problem.  The other problem is in the banking systems.  European banks hold large quantities of their own government's securities; as the price of those securities falls, their capital position worsens.  Meanwhile, they are also threatened by rising currency risk: the more it looks like the peripheral countries may need to leave the euro, the more people want to take their euros out of the country, rather than see their assets devalued.

This week, a few stories suggest that our worst fears are being realized.  In Greece, the "silent bank run" goes on:

In one of the biggest banks in the centre of Athens a clerk is explaining how his savers have been thronging to pull out their cash.

Wary of giving his name, he glances around the marble-floored, wood-panelled foyer before pulling out a slim A4-sized folder. It is about the size of a small safety-deposit box - and those, ever since the financial crisis hit Greece 18 months ago, have become the most sought-after financial products in the country. Worried about whether the banks will stay in business, Greeks have been taking their life savings out of accounts and sticking them in metal slits in basement vaults.

The boxes are so popular that the bank has doubled the rent on them in the past year - and still every day between five and 10 customers request one. This bank ran out of spares months ago. The clerk leans over: "I've been working in a bank for 31 years, and I've never seen a panic like this."

Official figures back him up. In May alone, almost €5bn (£4.4bn) was pulled out of Greek deposits, as part of what analysts describe as a "silent bank run". This version is also disorderly and jittery, just not as obvious. Customers do not form long queues outside branches, they simply squirrel out as much as they can. Some of that money will have been used to pay debts or supplement incomes, of course, but bankers put the sheer volume of withdrawals down to a general fear about the outlook for Greece, one that runs all the way from the humble rainy-day saver to the really big money.

Meanwhile, in Italy, banks are having difficulty tapping credit markets:

In Italy, one of the country's biggest banks, UniCredit SpA, faced numerous questions from analysts about the bank's short-term loans and whether disruptions in the funding market pose a threat. Executives acknowledged the market turmoil was having an impact, but downplayed its severity.

" available in the market. It's very, very short [term], but available," one senior executive said.

Short-term funds typically are less stable and more expensive than longer-term commitments, one of the reasons why banks and regulators try to limit their reliance on short-dated funds.

As Kevin Drum notes, "When that happened to Lehman Brothers, it had about a week left to live. The overnight market can dry up -- well, overnight if a bank's solvency comes into question. "

Spanish and Italian bond yields have stabilized on speculation that the European Central Bank is going to intervene, but they've stabilized at a very expensive level over 6%.  Moreover, the history of this crisis shows yields stabilizing briefly every time there's a new plan, and then resuming their rise.  Every time bond yields rise, the price of those bonds is definitionally falling, which further impairs bank capital in vulnerable nations.

Markets certainly don't seem sanguine about all this.  The Swiss central bank just cut interest rates to zero in order to discourage frightened investors seeking safety in their currency; the franc has risen 42% since 2008, and the Swiss don't like it.  On our side of the pond, this morning, CNBC is reporting that Bank of New York is now charging people a fee for large cash deposits because they're overwhelmed with people trying to ride out the storm on a pile of cash.  That's right, the Bank of New York is now offering what amounts to a negative interest rate if you try to deposit an excessively large chunk of dollars.

Normally, you stop a bank run with a sovereign guarantee.  But of course, the problem is precisely that the sovereigns are not in any position to be making guarantees. (This was also the problem with Credit Anstalt, the Austrian bank whose failure in 1931 triggered a wave of bank failures worldwide, including the second banking panic that really made the Great Depression, well, not-so-great.)  In theory, the EU could step in, either in the form of the European Central Bank or guarantees from the core.  In practice, while I find this somewhat plausible in the case of Greece, I find it fairly unlikely in the case of Greece, Portugal, Spain, Italy, and Ireland . . . which is what we're looking at.  (For that matter, why stop there?  Have you taken a look at Belgium's debt-to-GDP ratio?)

I don't know how this ends.  But I don't think the answer is "well".