The decision by the European Central Bank (ECB) on April 7 to raise interest rates a quarter percent to 1.25 percent, effective April 13, signals that the bank is slowly ending its accommodative monetary policy. The combination of rising energy costs and Germany's robust economic recovery arguably threatens to keep headline inflation above the ECB's target of 2 percent per annum, and this explains the decision to some extent. However, considering that the eurozone financial backstops are in place and functional (particularly, the European Financial Stability Facility) and that the bailouts of Greece, Ireland and Portugal appear to have alleviated concerns about those sovereigns for now, the rate hike probably has more to do with pressuring eurozone politicians to fix their troubled banking systems. In STRATFOR's July 2010 overview of the European banking sector we identified the underlying causes of Europe's financial sector weakness. To summarize, European banks are suffering from a decade of gorging on cheap liquidity that had led to local subprime bubbles across the continent. This means that a majority of Europe's banks are sitting on potentially "toxic assets" whose value remains uncertain. Meanwhile, a combination of self-imposed austerity measures, a raft of new regulations and long-term demographic trends will complicate banks' ability to grow their way out of their problems. The eurozone may have one monetary policy, but it has also 17 closely guarded financial systems. The historical links between Europe's states and their respective financial sectors makes European-wide policy coordination difficult. While the ECB can conduct monetary policy for the eurozone as a whole, it cannot force Dublin or Madrid to restructure its banking system, at least not directly. Moreover, unlike Americans, Europeans view the development of the financial sector as a nation-building project, and therefore it is highly politicized. European nations and their financial sectors co-evolved, and this explains their symbiotic relationship — the links between governments, banks and corporations have been encouraged throughout history and remain entrenched in a number of countries to this day. This is particularly the case in Germany, which is perhaps the eurozone country most reluctant to restructure its financial sector. Given Berlin's leading role throughout the sovereign debt crisis as the country making the tough decisions, engineering solutions and enforcing fiscal discipline, its reluctance to make needed reforms in its own banking system puts Berlin in an awkward position.

The Financial Sector: The Economy's Circulatory System

The financial system is the heart of the economy. Just as the human body needs oxygen, which the heart pumps through the circulatory system, economies need credit. The financial sector, then, is responsible for pumping credit through its branching network, from banks to businesses, households and individuals. The healthy functioning of the financial sector is thus critical to the economy overall. The pulse of the financial system is the wholesale funding market. Banks do not always have the funds they require. When a bank is short cash due to depositors' withdrawals or covering losses, for example, or for want of expanding the asset side of their balance sheet, they can borrow from other banks on the interbank market. The average interest charged on such funds is called the interbank rate, which varies depending on the duration of the loan. Banks can also borrow on an unsecured (uncollateralized) basis from the capital markets, where the price of such wholesale funding is heavily influenced by the corresponding interbank rate. The availability and pricing of wholesale funding greatly influences the pace of credit expansion, which in turn influences the pace of economic growth and inflation, which is why central banks pay close attention to it. The central bank guides the pace of credit expansion by influencing the pricing and availability of wholesale funding. Whenever a bank extends credit, it increases the supply of money in the financial system because that money is now both on deposit (from the depositor's perspective) and on loan (from the borrower's perspective). Since the act of making a loan effectively magnifies that money's presence in the financial system, banks act as money multipliers, so when banks are borrowing money, credit and money supply growth can grow too quickly. To prevent that, the central bank regulates this process by requiring banks to keep a share of their reserves on deposit at the central bank. Since this reserve requirement creates a structural liquidity shortage within the banking system, the central bank can then influence the interbank rate by manipulating the nature of that deficit — specifically by adjusting the quantity and/or price of money that it lends back to the banks in its liquidity providing (and absorbing) operations. In theory, since interest rates at the longer end of the curve are essentially a compound function of rates at the short end, central banks tend to focus on the interbank rate for overnight (O/N) funds, and their near absolute control over short rates is by far their most important tool. When the central bank wants to adjust the rate of economic expansion, it determines the O/N interest rate consistent with its objective and then adjusts the marginal amount of liquidity in the financial system accordingly. In this way, the central bank can be thought of as a sort of pacemaker that controls the heartbeat of the economy (recognizing, of course, that in this anatomy, a higher rate means slower activity, and vice versa).

The 2008 Financial Crisis: The ECB's Accommodative Measures

When the financial crisis intensified in late 2008 banks became increasingly reluctant to lend money — even to other banks, simply overnight, at any price. The monetary transmission mechanism was consequently broken, severing the ECB from its control over the economy. To prevent the financial sector from collapsing and bringing the economy down with it, the ECB introduced a number of extraordinary measures, the most important of which was the provision of unlimited liquidity (for eligible collateral) at the fixed rate of 1 percent for durations up to about 1 year. This was quite extraordinary, as the ECB usually just auctions off finite amounts of one-week and three-month liquidity to the highest bidders. (click here to enlarge image) While this policy prevented the financial system's complete collapse, it did so at the cost of the ECB's becoming the interbank market and clearinghouse. The introduction of unlimited liquidity meant that the supply of liquidity in the financial system was no longer determined by the ECB, but by banks' demand for liquidity. Since they could not obtain funding elsewhere, many banks borrowed enough liquidity to ensure their own survival. Collectively, these decisions resulted in a financial system characterized by excess liquidity, sending the O/N rate toward its floor — just above the deposit rate at the ECB (25 basis points) — as the ECB was really the only bank willing to absorb excess liquidity. Therefore, while this policy might have enabled the ECB to re-establish the interbank market, since it was no longer controlling the O/N rate, the ECB was no longer in control of the economy. The only way to regain control of the economy was to regain control of short-term interest rates, and that required restricting the supply of liquidity. However, the immediate concern throughout 2009 and 2010 was ensuring that there would still be an economy to control later. The ECB's policy of fully accommodating banks' appetite for liquidity propped up the eurozone's financial system because it entirely assuaged liquidity fears and cushioned banks' bottom lines; it even helped to support the beleaguered government bond market by motivating a virtuous circle therein (as the interactive graphic below shows). Since the liquidity the ECB provided was substantial, relatively cheap and of lengthy maturity, instead of simply using the loans to cover the books, eurozone banks invested it. Many banks used this borrowed money to purchase higher-yielding assets (like "low-risk" government bonds) and then pocketed the difference, a practice that became known as the "ECB carry trade." (click here to view interactive graphic) The ECB allowed this European-style quantitative easing to persist for almost an entire year, as the practice supported banks and, indirectly, government bond markets, which had been shaken by sovereign debt concerns. Over the last few quarters, however, the ECB had been urging banks to start finding sources of funding elsewhere because the eurozone recovery (particularly the German recovery) was gaining momentum, as was inflation; furthermore, the ECB wanted to send a reminder that its accommodative policies would not be in place forever. The question then became how to re-establish the actual interbank market and wean banks off the ECB credit. The genius of the unlimited liquidity was that, in combination with the fixed rates, the policy motivated the re-emergence of the actual interbank market automatically. Despite unlimited provisioning, the ECB liquidity was priced at 1 percent (annualized) regardless of duration, which meant that borrowing on the interbank market was much less expensive, particularly for shorter durations, where the excess liquidity had depressed rates. For example, borrowing one-week ECB funds cost 1 percent, but on the interbank market it was about half that, until only recently (see chart below). As some banks restructured and proved their health to their peers, they no longer needed or wanted to borrow excessive amounts from the ECB as an insurance policy, and as they borrowed less from the ECB and more from other banks, the interbank rates began to rise. And when the O/N rate drifted back up to the main policy rate of 1 percent, the ECB was once again in control of short-term rates and, more importantly, the economy. (click here to enlarge image) The problem now is what to do with the banks that have not restructured, cannot access the wholesale funding markets and are consequently heavily reliant on the ECB funding. The ECB is neither willing nor able to keep supporting these banks to this degree indefinitely. But instead of choking them off abruptly and risking creating an even larger set of problems, the ECB has begun to gradually wean these banks by maintaining unlimited liquidity (for the time being) but increasing its price. Each rate hike increases pressure on these banks and on their home countries' politicians to engineer a banking solution. The only way forward for these banks is to secure other sources of funding, and that requires restructuring and recapitalization. But therein lie intractable problems, which have nothing to do with finance or capital and everything to do with politics.

Restructuring: Three Categories of Banks

As the eurozone recovery has consolidated and the banking sector improved, the risk of an existential eurozone crisis has, for the time being, diminished substantially. These positive developments have, on the whole, led to the nascent recovery of lending to households and corporations, which corroborates the idea that the eurozone private sector might have turned the corner. (click here to enlarge image) Eurozone banks can be split into three general categories. The first is large banks with solid reputations that can access the wholesale funding markets and are doing so vigorously in 2011. The second is banks in Ireland, Portugal and Greece that are virtually shut out from the wholesale market due to concerns about their sovereigns' solvency, in which these banks hold large stakes, consequently rendering them almost entirely dependent on the ECB for fresh funds. The third category is banks somewhere in the middle that are struggling to access funding and will likely need to recapitalize and/or restructure in order to survive. These three categories are not set in stone, and banks can move from one category to another. The danger for Europe is that more banks in the first group will migrate to the last as the markets' focus shifts from the troubled sovereigns to the financial sector in both peripheral and core Europe. The first category consists of large European banks with solid reputations and strong sovereign support (or in the case of the two Spanish banks, a reputation that overcomes uncertain sovereign support). A non-exhaustive sample of these banks would include the German Deutsche Bank, French Societe Generale, Spanish Banco Santander and BBVA, Italian UniCredit, and Dutch ING Group. These banks are largely dependent on wholesale funding, but they are also able to obtain it. They have been aggressively raising funds in the first quarter of 2011 and have generally managed to fill at least half of their 2011 refinancing needs. For example, BBVA has raised almost all of its 2011 refinancing requirements of 12 billion euros ($17.2 billion), while Santander has raised about two-thirds of its 25 billion euro requirement. Deutsche Bank and UniCredit have only raised about a third of their 2011 refinancing requirements, but they should not have problems raising the remaining amount. Nonetheless, these banks have also been negatively affected by investors' lack of enthusiasm for banks' debt. Investors generally are skeptical of banks' balance sheets because, to the extent that the situation is transparent, they have seen little meaningful restructuring where it is most needed. The last eurozone bank stress test in particular did little to reassure investors and arguably made a difficult situation worse. So while the large banks listed above are able to raise funds, many — particularly the Spanish ones — have had to rely on instruments such as covered bonds, a collateralized debt instrument. The problem in Spain, however, is that as house prices continue to fall — particularly after the ECB interest rate increase — the assets covering these bonds drop in value, decreasing banks' ability to borrow against it. One way banks have offset this is by increasing the size of their asset pool by issuing more mortgages with the aim of using those additional assets as collateral to raise yet more funds. However, this plan is neither a prudent nor a sustainable approach to solving the underlying problem. The second group of banks comprises those in Ireland, Portugal and Greece. Their story is rather straightforward: These banks cannot access the wholesale funding markets because banks and investors have lost faith in these institutions and their sovereigns. The Greeks are assumed to hold too much of their own sovereign's debt (Greek banks hold 56.1 billion euros of Athens' sovereign debt, according to data from the Organization for Economic Cooperation and Development). Not only are these governments so deeply indebted that they may be unable to generate the cash to take care of their banking problems (let alone their budget deficits, even with bailouts from the European Union and the International Monetary Fund), but in Ireland's case, the banking sector is so troubled that even calling upon existing government support/guarantee programs might render the sovereign insolvent. These banks, therefore, remain reliant on the ECB for funding. According to figures from the ECB, Irish, Greek and Portuguese banks accounted for more than 50 percent of the 487.6 billion euros lent to eurozone banks as of February, even though the three countries account for only about 6.5 percent of the eurozone's gross domestic product (GDP). The last set of banks consists of those that have serious balance sheet problems related to gorging on cheap credit prior to the financial crisis, but that are not necessarily associated with troubled sovereigns. An example of this is Spain's Cajas, semi-public local savings institutions. The Spanish housing sector outstanding debt is equal to roughly 45 percent of the country's GDP, and about half of it is concentrated in Cajas. Cajas have no shareholders and have a mandate to reinvest around half of their annual profits in local social projects, which presents local political elites with the incentive to oversee how and when their funds are deployed (particularly right before an important local election). Investors are concerned that Madrid's estimating the cost of recapitalizing the Cajas to be around 15 billion euros is low, as other estimates place the figure as high as 120 billion euros. The actual number will probably be somewhere in the middle, but even if half of all the outstanding Caja loans remain unpaid (a reasonable worst-case scenario), the cost would amount to about 100 billion euros, or around 10 percent of Spain's GDP.

Germany's Political Hurdle to Restructuring

Similar to the Cajas are the German Landesbanken. The ownership of these institutions is split between the German states (Lander) and local savings banks. The idea of the Landesbanken was that they would act as a form of a central bank for the German states, accessing the wholesale funding markets on behalf of the much smaller savings banks. They do not have traditional retail deposits and have really only been able to raise cash by using government guarantees. However, as the global capital markets have become internationalized, the Landesbanken lost sight of their original purpose. In their quest for returns, the Landesbanken parlayed their state guarantees and funded risky forays into unfamiliar security markets with borrowed money, with devastating consequences. It is not entirely clear how expensive that learning experience will ultimately be, but estimates have placed the total bill at around 100 billion euros. Landesbanken are further weighed down by the often-unprofitable ventures of their state owners — the price of their aforementioned state guarantees. Thus, the Landesbanken have high loan-to-deposit ratios — generally about 30 percent higher than that of the highly leveraged German financial system as a whole. This reflects their reliance on wholesale funding and a dearth of retail deposits. One particularly troubled bank, WestLB, has a loan-to-deposit ratio of 324 percent when restricting the denominator to only consumer and bank deposits. The ultimate problem for the Landesbanken is that the people who run the German states are often the same who run the banks. The Landesbanken are 50 percent or more state-owned. While their business model no longer works and they are in woeful need of restructuring, they have been extraordinarily useful for local state politicians. This is a large problem for Europe as a whole, because Germany is the most powerful country in the eurozone and one that has pushed for austerity measures and fiscal consolidation on the sovereign level. When it comes to banks, however, Germany is resisting restructuring. For example, president of the German Bundesbank Axel Weber, one of the hawks on policy toward troubled peripheral eurozone sovereigns, has argued that in the upcoming second round of eurozone bank stress tests the various forms of state aid to the Landesbanken will be included as core capital, which goes against policies set up by the European Banking Authority. Berlin is determined that its Landesbanken should get special treatment so as not to fail the bank stress tests. Germany is therefore openly flouting Europe-wide banking norms for the sake of delaying the politically unpalatable restructuring of its banking sector. And if Berlin is not leading the charge, the eurozone has no impetus to reform its banks. STRATFOR was consumed by Europe's banking problems throughout 2008-09, and then in December 2009 the Greek sovereign crisis shifted the focus toward the sovereigns. With the Portuguese bailout soon in effect, Europe's peripheral sovereigns have largely been taken care of, for the time being. However, the ECB's support mechanisms that have enabled banks to procrastinate on restructuring are in the process of being withdrawn, again bringing into focus the moribund state of many European banks. This adds to the inherent problem — illustrated clearly in Germany — of the political nature of Europe's financial systems. The ECB is hoping that the normalization of its monetary policy will end the banking industry's reliance on its liquidity provisions. Assuming the sovereign debt crisis remains contained, we expect the ECB to continue providing unlimited liquidity in the near term, but to limit it in some way so that banks cannot forestall the inevitable for too long. We do not foresee meaningful bank restructuring taking place within the next four to six months, since it is clear that political will does not exist yet. The problem now shifts into the political realm. Restructuring may necessitate breaking long-held links between the politicians and financial institutions, and it may require state funding, which means more tax dollars used to bail out financial institutions — an idea that is extremely unpopular throughout Europe. The greatest worry is that Europe does not have a single authority to impose such painful political processes. It requires its most powerful country — Germany — to act as such an authority. Despite its leading role in addressing the sovereign debt crisis, Germany is clearly not eager to address domestic financial institutional reform.