The Walking Dead

Now that Europe’s fractionally reserved banking system has been regulated into complete inertia, it is a good time to assess the current bottom line, so to speak. We should mention here that there are essentially two ways of dealing with the banking system. One is to introduce an unhampered free market banking system based on strong property rights and nothing else. Such a system would work best if it were based on sound money, i.e., a market-chosen medium of exchange. The regulations governing such a system would fit on a napkin.


zombie bank2

Image credit: Warner Bros, processing fmh


The other way is to construct what we have now: a banking cartel administered and backstopped by a central bank, based on fiat money the supply of which can be expanded at will and involving continual violations of property rights. Fractional reserve banking represents a violation of property rights, because it is based on the assumption that two or more persons can have a legally valid claim on the same originally deposited sum of money (for an extensive backgrounder on this, see our series on FR banking – part 1, part 2 and part 3). This legal fiction is very convenient for the banks and the State, but it sooner or later renders the banking system inherently insolvent (a de facto, but not a de iure insolvency).


1-EuroStoxx Bank IndexThe Euro-Stoxx bank index, weekly, over the past 10 years. Recently the index has been unable to overcome resistance in the 160-162 area. The bust and the reaction of the authorities to the bust has made zombies out of Europe’s big banks – click to enlarge.


Given this system’s inherent insolvency, the regulations governing it obviously won’t fit on a napkin. Instead they fill several volumes the size of telephone directories and keep growing like weeds. In their infinite wisdom, Western regulators and authorities have decided to react to the crash of the banking system in 2008 by suspending the rules of capitalism. In short, they have done precisely what Japan’s authorities did after the 1989 bubble peak: They have completely zombified the banks. Amusingly, the very same people have criticized Japan’s actions sotto voce for decades.

Bank bailouts have proved to be politically unpopular. However, European and US politicians realized of course that it would be even more unpopular if depositors were to find out the hard way that the money they believe the banks to be “warehousing” on their behalf doesn’t actually exist. And so they decided to go with Plan A. Bailing out the banks has of course always been Plan A. One of the main reasons why e.g. the Federal Reserve system was established in the first place was precisely that it makes it possible to privatize the banks’ profits and socialize their losses. The other reason is that fiat money and a central-bank administered fractionally reserved banking system enable governments to impose the vile “inflation tax” and spend money they don’t have with both hands. This is extremely convenient for the financing of both welfare and, perhaps more importantly, warfare.

Nevertheless, the 2008 crisis (and the subsequent euro area debt crisis) scared governments, because it demonstrated the downside of having all these nice inflationary mechanisms at their disposal. The downside is that the large banks have simply become “too big to bail” after decades of unfettered money and credit expansion. A big enough crisis could eventually bring enraged mobs into the streets, wielding pitchforks and looking for someone to hang from the nearest lamp post. And so it was decided to zombify the banks, in order to prevent another round of bailouts (it is noteworthy that it was not decided to return to sound money and free banking – the idea is probably that business as usual can eventually be restored).


What’s 26 Billion Between Friends? Or 137 Billion for that Matter?

Among the many new regulations that are supposed to prevent future crashes are restrictions on proprietary trading by banks, but most importantly, new capital regulations which not only prescribe new minimum capital reserves, but also the composition of said capital. The latter rules have been used as a convenient financial repression tool, by declaring sovereign debt a “risk free” asset for which not a cent of capital has to be held in reserve (i.e., they have a “risk weighting” of zero). Banks (and insurance companies, which have also been hit with a slew of new regulations) have become captive buyers of government debt as a result.

This rule has incidentally already contributed to the complete ruin of private banks in Greece and Cyprus, which held primarily Greek government bonds. As it turned out, Greek government bonds were actually not “risk free”. We would submit that the same is true of all other government bonds: In reality, these debts can never be repaid, they can only be rolled over, at least as long as market confidence holds up.

As the Financial Times reports, a new study by JP Morgan has revealed that Europe’s biggest banks are still short of €26 billion in capital according to the newest rules in the works – or €137 billion, depending on one’s perspective:


“Europe’s biggest banks would need up to €26bn in new capital — hurting their ability to lend and pay dividends — if regulators’ efforts to level the playing field for the industry succeed, a new report has warned.

The European Central Bank has spent much of its first year as the eurozone’s banking regulator examining ways to stamp out national discretion that allows banks across 19 countries to calculate their capital differently. The Basel Committee on Banking Supervision is separately working on proposals that will limit banks’ room to manoeuvre in a variety of areas including how mortgages and trading assets affect key capital ratio calculations.

Regulators believe a level playing field would boost competition, but research from JPMorgan shows that the various “harmonization” efforts would have a serious financial impact on 35 of Europe’s biggest banks.

“One thing that is certain is banks will be constrained in lending,” said Kian Abouhossein, who led the team that wrote the 189-page report. “We see dividend cuts as the last resort of mitigation action before capital raises.”

Mr Abouhossein’s team found that the anticipated rule changes would reduce the combined Common Equity Tier 1 (CET1) ratios of the 35 banks by 1.5 percentage points by 2018. That is the equivalent of €137bn of their capital being destroyed.

JPMorgan’s report focuses on what the bank thinks investors — rather than regulators — will demand. By that measure, 13 banks will fall short by €26.4bn. Most banks target CET1 ratios of 10 to 15 per cent, well above regulatory minimums.”


(emphasis added)

The new regulations have turned out to harbor a great many “unintended consequences”. One we have frequently discussed in these pages is that the reduction in proprietary trading has eviscerated bond market liquidity – and with central bank policies creating a desperate “hunt for yield” among investors, this has created great potential to exacerbate the next financial market crash.

From our perspective it is actually not necessarily a bad thing if banks are constrained in their ability to create additional fiduciary media (i.e., money from thin air), as this makes capital malinvestment less likely. However, looking at this from the perspective of the planners, it will be considered bad news when credit creation stalls out. This will create fresh incentives for central bankers to increase the pace of central bank-directed monetary inflation in the form of direct debt monetization (a.k.a. “QE”), generating even more tinder for financial asset bubbles – all of which will eventually burst to devastating effect.

Keep in mind in this context that when private banks increase their inflationary lending, they are at least driven by the profit motive. While they are notorious for making huge and costly mistakes (see the mortgage credit bubble as a pertinent example), their decision-making is still based on economic calculation. The same cannot be said of central banks – they monetize endless mountains of debt, but there is no economic calculation involved – profit and loss are irrelevant to the central planners. They pursue diffuse goals such as “creating 2% p.a. of consumer price inflation” (no-one really knows what this is supposed to be good for) and “boosting economic growth” (which cannot be done by printing money, as it only ends up misdirecting and destroying existing scarce capital).


2-EuroStoxx Bank Index-STEuro Stoxx bank index, weekly – a close-up of the resistance area mentioned above – click to enlarge.


We can conclude from this that while the zombification of commercial banks makes them slightly safer for depositors and taxpayers, the long term economic effects of shifting the creation of money substitutes from the private sector to central planning institutions are unlikely to be wholesome. On the contrary, as fewer and fewer actors in the private sector are willing to invest or able to obtain funding for their investment plans, we have to expect government spending to keep growing and play an ever bigger role in the economy (see also the mad-cap plans of the EU and the G20 to splurge on government-funded and directed “investment”).



Bank profitability will remain under pressure for some time to come in light of the new capital regulations currently in the works. This will make it more difficult for banks to generate new capital internally, so they will have to tap the capital markets and dilute their shareholders further. It is no wonder that bank stocks remain way below the valuations they once commanded (we actually wouldn’t touch these stocks with a ten-foot pole).

From a wider economic perspective, the new capital regulations are rendering banks moderately safer for depositors (as long as the markets don’t lose faith in government debt that is), but they also contribute to their ongoing “zombification”. Bank lending is going to remain subdued. This wouldn’t represent a big problem, if not for the fact that it is likely to provoke even more government activism.


3-Euro Area TMSIn spite of weak bank lending growth, the euro area’s money supply is growing by nearly 14% annualized due to the ECB’s ongoing debt monetization program – click to enlarge.


Charts by: BigCharts, ECB



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