Stratfor: can Europe’s banks break free from their doom loop?

Summary: Banks are the financial heart of modern nations, and Europe’s are in trouble. One of its greatest, Deutsche Bank, has severe problems. Here Stratfor looks at the perilous state of Europe’s banks, looked in a doom loop by their holdings of government bonds.

Can the Eurozone Break Its ‘Doom Loop’?

Stratfor, 16 February 2017.

In 2012, Europe’s sovereign debt crisis exposed the “doom loop.” Created by European banks’ tendencies to hold their home government’s debt, the vicious cycle, in theory, starts when markets lose faith in a government’s ability to pay back its debt, precipitating a sell-off of its bonds. The resulting drop in bond prices would then hit the balance sheets of the banks that still hold those bonds, making them more likely to need a bailout from their governments. This, in turn, could further erode investor confidence, leading to additional sell-offs that damage the banks even more. Despite the danger that banks’ practices pose, eurozone regulators have yet to find a way to sever the loop.

In the years since a doom loop nearly led to the eurozone’s collapse, authorities have tried (but failed) to break the bond connection between banks and their governments. A German proposal to limit the amount of their own government’s debt that banks can hold has been hotly contested by Italy and Spain, since implementing it would cause massive disruptions to their economies. Another German-led measure involved the creation of “bail-in” rules, which were adopted at the start of 2016. They required that a troubled bank’s private debtholders absorb its losses first, essentially losing their investment, before government money could be used to bail it out.

National banking sectors most exposed to the debt of their governments.

The sovereign debt crisis that gripped Europe in 2011-12 exposed the existence of a “death loop” created when eurozone banks hold significant percentages of their home government’s debt. This can create a vicious circle in which bank insolvency raises the risk of government default, which further damages the banking sector. Today, Italy’s banks are the eurozone’s biggest holders of their own sovereign debt, making it Europe’s riskiest economy. Click to enlarge.

But since mid-2016, rising expectations of a return to inflation have driven investors to sell off their bonds. (Higher inflation reduces the attractiveness of bonds to investors, and bond markets have seen sharp sell-offs across the board over the past few months.) Those expectations have already played out in the eurozone, where the annual inflation rate rose from 0.2 percent in July to 1.8 percent in January. This has encouraged the European Central Bank (ECB) to scale back its bond purchase program, which it uses to stimulate inflation, from 80 billion euros ($85 billion) to 60 billion euros per month. With the ECB providing less support for bond prices, yields (which move in the opposite direction of prices) have risen. Mounting political risk in countries such as France, Italy and Germany has also magnified the sell-off’s effects.

Still, European authorities have not stopped searching for ways to correct the doom loop. In January, the European Banking Authority suggested the creation of a Europe-wide “bad bank” that could buy nonperforming loans from EU banks to get them off the banks’ balance sheets, thereby improving the sector’s financial health. The creation of European safe bonds, or ESBies, has also been gaining traction lately. The eurozone has entered a difficult year, regardless, and some investors are showing more and more doubt in its ability to survive. This is due, in part, because the doom loop between banks and their governments is still intact.

“Can the Eurozone Break Its ‘Doom Loop’?” is republished with permission of Stratfor.

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