September 15, 2011

Europe’s banking crisis — and “crisis” is used advisedly — tells us how much and how little has changed since the onset of global financial turmoil in September 2008. Then, people worried about the viability of major American banks, loaded with “toxic” mortgage-backed securities whose value was difficult to determine. Now, people worry about major European banks, loaded with government (a.k.a. “sovereign”) bonds whose value is difficult to determine. We are flirting with another financial crisis not unlike the post-Lehman Brothers panic.

This need not be. In 2008, no one knew how government would respond to the siege of U.S. banks and financial markets, which couldn’t raise the funds needed to support existing loans and investments. Now we know: Government — via the Federal Reserve and the Troubled Assets Relief Program (TARP) — provided the money to avert a financial collapse. In Europe, something similar is now happening: The European Central Bank (Europe’s Fed) is already lending to banks struggling to borrow in private markets; indeed, the ECB announced a new loan facility on Thursday.

The ECB’s safety net can buy time, but it can’t solve the underlying problem: banks’ exposure on sovereign debt holdings. A Greek debt default — regarded by many economists as inevitable — would almost certainly cause Irish, Portuguese, Spanish and Italian bonds to drop in value, reflecting fears that these countries might default. In March, Europe’s banks held almost $2.2 trillion of these countries’ debt, according to data from the Institute of International Finance, an industry group. Weakened banks would tip Europe into recession.

We would feel it; so would the rest of the world. Europe accounts for about 22 percent of U.S. exports. It provides perhaps an eighth of the foreign profits of major U.S. multinational firms. U.S. banks and investors would suffer losses on their European loans and investments. Large U.S. money-market funds have lent $658 billion to European banks, though exposures have recently declined sharply, reports the credit agency Fitch.

In theory, Europe’s banks ought to have ample capital to absorb large losses. In practice, they may not. The rating agency Moody’s recently downgraded two big French banks on fears of losses. To understand the problem, it’s necessary to explore the world of bank capital.

Capital consists mainly of shareholders’ equity and some long-term loans. Global capital rules — referred to as Basel I and Basel II after the Swiss city where negotiations began — vary the amount of mandated capital by the risk of the covered investment. This seems sensible: Riskier investments require greater capital protection. But it hasn’t worked well in the real world.

Under Basel I, banks were required to hold 8 percent capital against most assets. Ordinary loans to companies required 8 percent: That’s $80,000 on a $1 million loan. By contrast, home mortgages required only 4 percent; they were considered safer. Later, “securitizations” of “prudentially” made mortgages required only 1.6 percent; they were judged even safer. And most government bonds required no capital; that’s how safe they were rated.

Not surprisingly, banks favored investments with low capital requirements. American banks liked mortgage-backed securities; European banks gorged on sovereign bonds. The perverse result: The very securities — mortgage debt, government debt — considered safest became the vortex of the crisis.

Later, Basel II gave banks discretion — with regulators’ approval — to rate the risks in their portfolios by their own computer models. With this freedom, could it be that European banks decided (surprise!) that their portfolios aren’t very risky and don’t require much capital? This seems possible. Amazingly, many major European banks (Deutsche Bank, Societe Generale) have only 30 percent of their total assets covered by capital set-asides, according to an analysis by JP Morgan Chase.

Put differently: Most assets seem unprotected by capital. For American banks, which are adopting the Basel II rules more slowly, this problem seems much smaller.

So Europe’s crisis comes into focus. No one knows what all the banks’ government bonds are worth — or will be worth in the future. No one really knows how much protection is provided by capital and how much added capital might be necessary. A leaked staff estimate from the International Monetary Fund suggests 200 billion euros (about $270 billion). The uncertainties are huge. What happens when lots of money is at stake and investors don’t know what they need to know? The Lehman episode provides an answer: They panic.

That’s why the combination of huge sovereign debts and vulnerable banks could trigger another financial crisis. To restore confidence, Europe’s banks need to increase capital. Admittedly, this won’t be easy. Private investors may resist investing; governments are already strapped. But leaving these problems unattended — as Europeans have — could return us to the fall of 2008. That’s not where anyone wants to be.