On the brink of a global blow-up

The concurrence of S&P's bank reviews and central bankers' liquidity agreement shows just how close Europe's crisis has come to the kind of disaster so narrowly averted in 2008.

It was a neat and timely coincidence, and reminder, that Standard & Poor’s chose this week to downgrade some of the world’s largest banks, including the major Australian banks, even as central bankers took coordinated action to pump liquidity into the global financial system.

It was a coincidence – the ratings review had been in the pipeline for a long time – but the concurrent developments amplify the underlying message that the inability of the European authorities to come up with a consensus response to the deepening eurozone crisis has brought the system back to the brink of the kind of catastrophe so narrowly averted in the immediate aftermath of the Lehman Bros failure in 2008.

The markets’ response to the central banks’ action – a momentary ‘relief rally’ – misread the implications of the move. Central bankers only take that kind of coordinated action when they are truly, truly concerned.

Whether or not there were individual European banks on the verge of failing, as some speculation suggested, there is little doubt that funding markets for banks – and particularly but not exclusively European markets – were seizing up. If that continued for any length of time there would be bank failures, so the intervention was a signal of distress.

It is also just a temporary measure. It doesn’t address either the solvency of various nation states within the eurozone or the solvency of the eurozone banking system, which are interrelated.

Until the eurozone authorities come up with a plan to address those issues – lowering the debt burdens and/or borrowing costs of their most vulnerable members and recapitalising the eurozone banks to fill in the holes created by their exposures to sovereign debt – banks will be leery of lending to each other and markets will be extremely reluctant to provide funding.

The central banks may have bought the Europeans a little time but infusions of liquidity and some temporary lowering of borrowing costs doesn’t address the fundamental structural problems in the region and the threat they pose to the global financial system and economy.

The S&P downgradings reflect a change in its methodology that looks beyond the health and stability of individual institutions to the state of the economies in which they operate and in that sense picks up the symbiotic relationship that has developed in Europe between the stability of the eurozone and the stability of its, and others’, banks.

It is instructive that the world’s most highly rated bank, the Dutch cooperative Rabobank, which had been the only AAA-rated bank, suffered a two-notch downgrading to AA, largely because of its location rather than its own financials.

Ratings agencies always seem to operate with hindsight, so S&P’s actions only confirm what has been obvious for some time. For some banks, however, the downgrade will mean an increased cost of funding and potentially the need to raise more capital.

The Australian banks, while suffering a one-notch downgrading, retained their privileged status among the handful of banks in the world to hold a AA rating. While there was some focus today on the two-notch downgrading of Macquarie Group, to BBB from A-, the rating that matters to the group – the rating for its banking business – remained at A.

As various Business Spectator columnists have been writing consistently since 2008, the point of vulnerability for the Australian system has always been its reliance on wholesale markets for a substantial proportion – close to 40 per cent – of its funding.

Despite the remarkable inflows of deposits, and the very prudent and substantial build-ups of capital and liquidity, that dependence remains the most obvious point of vulnerability for the majors.

Having said that, the Australian banks are in a stronger and more conservative position than almost every other system in the developed world and the Australian Prudential Regulation Authority and Reserve Bank have already put in place mechanisms for providing emergency liquidity, at a price, should funding markets freeze for any significant period.

All the majors say they could survive for at least several months without any access to wholesale debt markets. If those markets were closed for months, the fate of the Australian banks would, in a sense, be of far less consequence than what it would say about the global banking and financial system – which presumably would have imploded by then.

The injection of liquidity into the system by the central banks – and the heightened attention the S&P downgrades draw to the environment individual banks are operating in, as well as their own conditions – highlights the linkage between what’s happening, and not happening, in Europe and the threats this poses to global financial stability.

Presumably the central bankers have conveyed some more private messages of their concerns to the eurozone authorities as well. The time is running out for some substantive response by those authorities to avert what would otherwise almost inevitably be a disastrous outcome, and not just for the eurozone itself.

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