Financial markets’ growing concern about the state of European banks exposes a reality that the political theater in the U.S. had obscured: The euro area’s debt troubles are probably the single largest threat to the global economy.
The share prices of European banks, and in particular France’s Societe Generale SA, have plunged in recent days as investors speculate that the banks could be facing investment losses and difficulties borrowing money. SocGen has denied the rumors, but the nature and veracity of the specific concerns is almost secondary.
European leaders have created a fertile ground for panic by failing to dispel the main uncertainty: How they will resolve the financial troubles of strapped euro-area governments, how much banks holding the governments’ bonds stand to lose as a result, and whether the banks can be bailed out.
Investors’ dark view demonstrates how costly uncertainty can be. Consider, for example, the market value of bank equity compared with how much the banks say they’re worth in their financial statements.
As of Thursday, SocGen’s market value stood at only 52 percent of tangible common equity, suggesting that investors think it will need about 16 billion euros ($22.8 billion) in fresh capital to cover losses, according to data compiled by Bloomberg. For a group of 31 European banks, the market-to-tangible-equity ratio was just under 70 percent, implying they collectively face losses that would require some 137 billion euros ($195.1 billion) in capital to offset.
European bank troubles matter for the U.S. and the rest of the world, in part because the money-market funds in which millions of U.S. households keep their savings have invested heavily in European bank debt. Trouble at money-market funds would disrupt the short-term lending markets on which U.S. companies depend to pay suppliers and their own workers. Much as after the Lehman Brothers Holdings Inc. bankruptcy, the resulting credit freeze could force companies to slash production and fire workers, triggering a sharp recession in the world’s largest economy.
Ideally, Europe would conduct stress tests showing exactly how much banks can lose and immediately announce how they will raise the necessary capital, much as the U.S. did in 2009. But no stress test can be credible until European leaders own up to the fact that some governments can’t pay all their debts, define the losses investors will take and put a system in place to guarantee the debts that can be paid.
As Bloomberg View has advocated, the best route to clarity -- and stability -- would be for all the governments of the euro area to issue new bonds guaranteed by a unified finance ministry with taxation power. Investors would exchange the debt of individual governments for the euro bonds, probably at discount rates that would erase some of the debt at the investors’ expense. The remaining sovereign debt would be sustainable. Banks and investors would know the extent of their losses.
It won’t be pretty, but ultimately the bloodletting will have to happen.
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