December’s Real Top Event – By Far – Happens This Week: Part 3

The EU’s SRM banking pact to be finalized December 18: new beginning, or beginning of the end?

Part 3 of 3: Conclusions: A Giant Step…To Nowhere

In our weekly  analysts’ meeting, in which we share thoughts and conclusions about the weekly outlook for global equities, currencies, and commodity markets, we noted that the results for past week’s Euro group and ECOFIN meetings’, which hammered out all but a few final details of the SRM deal,  were far too underreported relative to their importance.

The following is part 3 of a special feature on the coming a single resolution mechanism (SRM – get to know this acronym) for dealing with troubled EU banks.

See part 1 for introduction, background and general themes reflected in the negotiations and terms

See part 2 for summary and analysis of specific key terms, including their risks and dangers



The good: The SRM per the terms in part 2 suggests that the EU will eventually have a degree of centralized supervision and common fund. The current SRM is a substantive step in the right direction.

The Bad: Per those same terms, the SRM sadly reflects the EU’s tradition of too little too late, and risks achieving the opposite of its goal – scaring markets and undermining its credibility. Dangers include:

SRM Underfunded: Doom Loop Alive and Well

Inadequate funding, on both the common EU and individual member state level, mean that there won’t be enough cash on hand to reassure markets that  when EU stress test results come out in December, failing banks will not threaten the EU  or financial markets. That brings the following dangers:

Member states that cannot afford it are still responsible to bail out their own troubled banks – doom loop is alive and well in much of the EU.

Equally bad, the ECB will know this, markets will know that the ECB knows it, and will be skeptical about the rigor or honesty of the tests – the EU risks further loss of credibility.


SRM Looks Too Slow, Too Decentralized


The process for failing banks getting needed aid, from bail ins, then national funds, then the EU, looks too slow, bureaucratic, and prone to drawn out conflicts, to respond quickly enough to emergencies to avoid scaring markets, depositors, and lenders.

The new central supervisory body, the European commissions’ resolution board, has only minimal power compared to the committee of member states. Good luck getting a quick decision out of 28 governments.



The goals of the SRM deal were to create a clear, well-funded mechanism for dealing with banks that fail the coming ECB stress tests and future troubled banks. In sum, create a safety net for troubled banks.

In other words, is the SRM likely to break the “doom loop?” Can it end or significantly reduce the threat of insolvent banks to drag down their sovereigns, the EU, and/or global economy and markets?

That is the question.

If the answer is yes, then the SRM would then allow the EU or its members to:

  • To conduct rigorous stress tests knowing that troubled banks will not cause fears of insolvency, bank runs, or credit freezes, and thus it could
  • Find the bad banks
  • Recapitalize or close them without causing economic or market turmoil or crises
  • Clean up its banking system, continue to unify it, and heal both its reputation and ability to function.

So, does the SRM break or materially weak en the doom loop? Do the terms of the SRM deal as they currently stand, create that safety net that allows the ECB to conduct credible stress tests and allow troubled banks to be recapitalized or closed without rattling confidence in the EU?

To answer that, we have to ask, and answer, the following questions.

  1. Is there enough cash in the common EU fund to deal with troubled banks without risking sovereign insolvencies and plunging values of their bonds that further destabilize their banks?


The short answer: No. In the next 5 years, it’s very unlikely; after that point, it’s still unlikely. In sum, there are real doubts about whether the cash will be there. This lack of clearly abundant funding alone could be a fatal flaw of the whole SRM and kill the unification movement before it gets going

Here’s why.

In the period immediately following the 2014 stress tests (not due to be completed with results published until September 2014) and first few years that follow, the answer is, probably not.

Remember that the common fund is to be built up 10% per year over 10 years, so it will be 5 years before the fund has even half of the 55-70 bln euros, 22-35 bln euros. Given the size of past bank bailout noted in Part 2, that’s probably not enough for even one major national bank rescue deal.


  • Member most states (ex-Germany) have generally not set aside much or any funds for aiding their own banks. See here for details. EU credibility will only be further damaged if markets see banks backed by promises rather than cash. Again, member states don’t have the option of the printing press, real or electronic, like the US, Japan, UK, etc. So unless Germany suddenly reverses half a century of opposition to potentially inflationary money policies (current deflation threats haven’t swayed it yet), don’t expect the EU to allow a wave of money printing or its virtual equivalents unless faced with a dire emergency.
  • These early years immediately following the 2014 tests, which will uncover new capital short falls (estimated at anywhere from 50-90 bln euros, depending on who you ask) that are likely to be the ones when the need is greatest.

Thus neither individual states nor the common EU SRM fund are likely to have enough cash in the tank when they most need it.


  1. Even if the funds are there, can the GIIPS and other cash-strapped sovereigns get access to those funds, and get them quickly enough to avoid periods of uncertainty about the solvency of that nation’s sovereign and/or banking system?


Answer: Probably not. As we saw in part 2, nations must first exhaust both potential bail-in funds totally 8%, then national funds. That pits potentially powerful groups of large depositors and taxpayers (both with allies in their governments) in potentially drawn out fights. After that, there’s the voting process and approval process involving the council of member states and the EU’s resolution board. In short, the current multi-step process looks too slow to respond to emergencies. At minimum, it casts doubt and uncertainty on the EU’s ability to move fast when it must. That means in times of emergencies we’re right back to running to the Troika and Germany.



  1. Even if the answers to the above are ‘yes’ are the costs created by requirements to accessing these funds (must exhaust bail in and national funding first) low enough so that the benefits or accessing the EU funds outweigh the costs for cash strapped nations (virtually all of the EU ex-Germany)? That is, even if the cash is there, and can be gotten quickly, are the nations that need the aid for their banks materially better off than before?

Answer: It’s very unclear that the weak states and banks that could present systemic risk are any better off. Bail-ins suggest the risk of bank runs and being shut out of bond markets. Using national funds that are inadequate mean they must fund funds elsewhere in their budgets, aka more austerity. Attempting to access EU funds controlled by Germany likely means that even if cash is available, it will come with more austerity demands and/or other conditions that might mean political suicide. That means states are tempted to try the usual brinksmanship. They threaten contagion, in the end agree to harsh terms, ignore them, etc.


Beyond questions about these basic risks and dangers, there are others related to the long period of uncertainty about the test results, stretching from the start of the tests in early 2014, to the expected release of results in September 2014, assuming no delays (?).  That prolonged period of uncertainty carries its own risks and dangers. These include:

  1. Risks of leaks and rumors about failing banks that could send those exposed to losses from bail in risks (depositors and lenders) fleeing, turning healthy banks into unhealthy ones. Even though bail-in rules don’t apply until 2016, those at risk are unlikely to keep their funds in banks rumored to be in trouble, given the risks that the 2016 date could be moved up yet again. These problems will of course most likely appear in the weakest economies and banks, the ones least likely to survive these challenges.


  1. Risks of reduced growth and more deflation from further lending cuts as banks prepare for stress tests. How does the EU prevent further reductions in bank lending at a time when it needs increased lending to smaller, riskier borrowers to help keep growth and inflation from falling further than it already has in most of the EU? Impending stress tests discourage lending to all but the most creditworthy borrowers. The lack of details in the coming months about how banks will be tested only increases bank caution.


  1. How will the ECB stress sovereign bond assets? If the stress tests are rigorous, these bonds will not be rated anywhere near riskless top tier capital. However, after the ECB’s LTRO program encouraged banks to borrow at low rates in order to buy higher yielding GIIPS bonds, EU banks are loaded with risky GIIPS bonds. For example, a few weeks ago we cited a report that Italian banks hold so much Italian bonds that they’re near saturation point. In other words, the ECB must choose between tests that recognize the true risk of GIIPS bonds and severely marking down many banks’ capital.


  1. If the above don’t suggest enough of a challenge for the ECB, here’s another one. The ECB team handling this delicate process will be a newly formed group. Salaries offered aren’t luring needed talent from the private sector. Instead the ECB is getting staff from national authorities that may well bring their own old loyalties. Not an ideal recipe for preventing leaks.




Barring a major change in terms on December 18th or thereafter, SRM is too little too late,

  • Too little in terms of near term funding or real centralized, streamlined decision making
  • Too late in terms of getting the national funds or and common EU fund ready. It will be 5 years before the common fund is even close to ready for even one bailout on the scale of prior bank bailouts. Meanwhile most of the EU, particularly the GIIPS, remain stuck with stagnant growth, so it’s hard to see them seriously building up bank bailout funds.
  • Thus we expect the same behavior as in the past. Promises, plans to make plans, no action until the last minute, and much of that is just more lending with printed or promised funds due at some point too far in the future to worry markets.

Given the likely answers to the above, what can investors do to profit or at least protect ourselves?

In the short term: EU stocks and the Euro are acceptable trading instruments for long or short positions depending on near term technical and fundamental factors. The current uptrend in the EUR and European stocks is a good example of how despite dubious long term fundamentals, they both trend higher on a combination of near term fundamental and technical factors.

In the longer term: The minority of relatively strong banks and sovereign bonds could become highly sought after shelters.

Beyond that, I’m not comfortable recommending long term shorts on peripheral assets, as much as common sense suggests that given the GIIPS dire fundamentals.

The SRM suggests bad choices (punish voters or investors?) and desperate times. Those invite government interventions that are unpredictable. For example:

  • 70% (or was it 90%?) ‘voluntary’ haircuts on Greek bonds that aren’t considered a default for CDS (default insurance) purposes.
  • Two years ago bail-ins were unthinkable because they invite bank runs and high borrowing costs. Now they’re about to become standard policy. Are you really ready to invest in anything connected to GIIPS banks?

If bail-ins are a high risk in the GIIPS nations, how do these countries prevent bank runs unless they impose capital controls?

I wish I could be more optimistic. Have I missed something?

Oh, yes. The SRM’s failings suggest that the long term uptrend of the USD vs. the EUR will hold, and that the current EURUSD uptrend is something we watch, wait for it to begin reversing, then short.

That process isn’t happening yet, so continue to respect the bullish EUR trend. Note that our real time sample of retail traders have become more bearish on the EURUSD, (31% long 69% short) than their usual (since November 1st) ~36% long 64% short, probably due to speculation on a fed taper coming sooner.


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