Can Super Merkel save the Euro? - Market update

Nothing really happening recently on financial markets that have been quite snoozy lately. No news is good news? It seems like it. Despite the lack of any update on ECB's (European Central Bank) intervention on markets or any good economic figures, European markets are rallying (Friday : IBEX 35 = +1.94% - FTSE 100 = +0,31% -  DAX = 0.64%) - supported by the financial sector dynamism (Bankia went up  50% two weeks ago due to the fact that the financial aid it needed is to be completed in a very near future). The spanish 10 yr bond dipped from 6.84% to 6.54%, as well as the Italian 10yr bond even though its decrease hasn't been as sharp as the Spanish'.

The main underlying question laying behind this flitting momentum is the following : Will Merkel and Germany allow and proceed to purchases on the secondary bond market by European institutions to lower bond yields. It appears that this option is pretty much the last one that could save the Euro if uncertainty and poor confidence still characterise the market over the next few weeks. In fact, analysts believe that the euro bailout funds would not be sufficient to provide a full bail out to both Spain/Italy, which would cost at least  € 1 trillion  (bail out funds amounts to approximatively  €700 millions.

Hence in this scenario, the only safety net is the possibility of the creation of a banking license to the ESF (European Stability Fund) , which would enable it to create and pump in money in Euro distressed bond markets to lower yields. This is of course a very well-intended proposal despite the risks of inflation - increasing the monetary base would enable the ESF to lower yields in peripheral euro countries  and give them time to reduce their structural deficits (as opposed to cyclical deficits). Sounds nice in theory, and the only thing really left to us is to hope that it will be "enough".

Unfortunately, there is quite a large room of concerns on this ECB "Quantitative Easing for Southern European Countries"

The Bundesbank, Germany and Northern European countries except France are quite strongly opposed to ECB's possible intervention. They consider that those kind of actions should be decided by parlements and not by central banks, and are worried it may become an 'addictive drug' without solving the roots of the problem.

And that's the core of the problem. There is no doubt that bond yields will go down if ECB decides to intervene in the market - at least in the first place.

Markets will even respond positively and rally for a bit. 

But over the long-term many concerns will remain, and risk mitigation is highly unlikely. Why?  :

1.  Will a real fiscal and bank union will take place? This sounds really doomed as both sides stand their ground and do not seem keen on a compromise. Germany and Northern European countries are not willing to increase inflation in their countries (pay rise or any other minimum wage) and the rest of Europe leaders are having a hard time cutting down on social benefits and other public bodies. No compromise = No union = Higher perceived risk by markets. 

2. Lower bond yields are likely to be only a fad. Why? Many hedge funds and other participants in the bond market sell their holdings after public intervention in the market. In fact, if the ECB buys bonds it will be a preferential creditor of Spain. In other words it will be repaid first and before any other creditor (ie : hedge funds, banks..). This creates an additional risk and this result in bonds sell-off, more information here : http://www.businessinsider.com/the-basic-arithmetic-behind-investors-biggest-fear-in-europe-2012-8

Lower yield means a higher bond value - hence many bond holders leave the market after public intervention. Except if growth expectations improve in the long run, nothing will really prevent bond yields to spike up again.

3. ECB buying bonds is likely to spark up some tensions amid distressed Euro countries (Portugal,Ireland..). Those countries have even higher borrowing costs than Spain or Italy (9.45% for the Portuguese 10Y - 8.2% in Ireland and more than 20 in Greece). Their reasoning is the following : Why would this country get the help of the ECB to have lower borrowing rates when mine does not? The role of the ECB is meant to be impartial and not to favour any country specifically - which is particularly opposed to a such intervention.

Breaking up the Banks or Too big to be broken up..?

Some very interesting events in the financial news appeared to have dust off the path to a bank breakup.

In the wake of the GFC and the numberous financial scandals tied to it (Lehman Brothers and the subprimes, Goldman Sachs,AIG..), a strong wave of popular discontent affected the financial sector. Investment banks were pointed out as responsible for the GFC because of their always more dicey bets jeopardizing current accounts of billion of individuals and threatening economies on a broader scale. After massive growth stimuluses of governments and the bailing out of many banks and financial institutions over the world, growth timidly restored confidence into the financial markets. Except few attempts in Europe to regulate markets (such as the Mifid), nothing much came out of our "uninspired" regulators.

However, we have recently seen voices being risen for more regulation in the financial sector. The roots of these claims are quite easy to identify - more financial scandals have been revealed lately ( JP Morgan and the London Whale, the LIBOR, tremendous bonuses package given after the GFC..) and the sector seems not to have learnt much from its mistakes and still has many blunders to be fixed. Even Sandy Weil, former CEO of the gigantic Citigroup, has said to be favourable to a bank breakup - stating that "(we should) have banks do something that's not going to risk the taxpayer dollars, that's not going to be too big to fail."

The main advantage of a bank break - up is quite obvious : no more "Too big to fail", in other words bailouts would no longer be necessary to save Banks if those have made "bad bets". Jamie Dimon, CEO of JP Morgan Chase - one of the biggest financial institution of the US and the World - revealed during its hearing of the $5.8 billion "London whale" trade loss the difficulty of clearing position of a such scale. The actual size of banking conglomerates puts extra pressure on clearing trades - the bulk positions that those banks take because of their "balance sheet" size - make it difficult for them to close these positions because of market liquidity. Hedging - more or less taking risk-off on a trade by taking another position - is even more complicated when trades are amounting to billions of dollars (see what Dimons says at 3.00) :

Globalization and the concentration in the financial industry has led to an odd facts : many European banks are now bigger than countries :





On the other hand, a regulation to break-up banks is quite complicated to make and would most likely take years to be put in place. On top of that, some bank CEOs and other economists question the real efficiency of a bank break-up. What are their arguments? According to former U.S senator Chris Dodd on CNBC, breaking up the bank is not the solution. In the short-run, it seems obvious that the banking sector would be substantially less profitable if it was to be broken up in two parts. In fact, the participation of banks in both investment & commercial banking enable them to lower costs (the funds banks need to invest come largely from client's deposits with economies of scale on top of that - even if this is to be restricted by the Volcker rule i.e proprietary trading rules). In addition, being part of the investment business can be seen as an incentive for commercial banking to lower interest rates - obviously having a stake on companies profits and the overall economic performance can  be a reason enough for banks to discount loans or at least not to "make too much" profit out of it. If US banks are eventually split, they will lose a part of their business activity and European banks, who do not have to be split between commercial and investment banking departments yet should logically benefit from the US split.

If a bank split up can definitely bring on many advantages in terms of risk management for individuals and countries economic stability, it will take a long time to be implement. It is not really about how big and how complete the regulation is in the end but about how efficient it is.

Is the financial sector too big? Indeed those last two graphs would need to be compared to some other countries since "developed" countries financial companies' have obtained market share from developing countries (which would explain for the increase on both exhibit) but it is still very interesting to take a look at it :




J.L