The European Banking Vortex: A Self-Reinforcing Cycle of Failure

The Perfect Storm of Banking Woes

A sudden and unexpected storm is brewing in the world of European banking, threatening to unleash a perfect financial storm that could have far-reaching consequences for investors.

The European debt crisis has been simmering for months, but recent developments suggest that the situation is rapidly deteriorating. Banks are struggling to access funding, credit growth is slowing, and confidence in bank safety is eroding.

The Self-Reinforcing Cycle of Bank Failure

At its core, the problem lies in a self-reinforcing cycle of bank failure. As banks' balance sheets weaken, they become less able to lend, which in turn exacerbates the economic downturn. This creates a vicious cycle where banks, sovereigns, and the economy are all interconnected.

The European credit system has traditionally relied on weak banks propping up weak sovereigns, while weak sovereigns have supported weak banks. As both parties weaken, the underpinnings of credit growth and economic activity are severely damaged.

The Squeeze on Bank Funding

Banks' access to funding is rapidly deteriorating. Long-term debt issuance has ground to a halt, and what little issue there has been has mostly been securitized. Short-term funding markets have also been squeezed, with Euribor-OIS spreads at elevated levels.

This squeeze is having a devastating impact on bank lending, which is essential for economic growth. The lack of credit is stifling business investment, consumption, and job creation.

Portfolio Implications: A Mixed Bag

For investors holding European banks like C, GS, QUAL, EFA, and BAC, the situation is dire. Bank equity prices are plummeting, while CDS spreads indicate a high risk of default. However, some banks, like those in Germany, still have relatively strong balance sheets.

However, the risks far outweigh the potential rewards. The self-reinforcing cycle of bank failure is gaining momentum, and investors should be prepared for a potentially catastrophic outcome.

A Plan B Is Needed – Now

The European authorities must act quickly to provide a credible plan for backstopping systemically important banks. This means bolstering their capital bases, providing emergency funding, or both.

Without such a plan, the consequences will be severe. Credit growth will continue to slow, economic activity will stall, and investor confidence will plummet.