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(Business Intelligence Brief) The European Central Bank (ECB) has a problem. That is any understatement of course as they have many problems. This, more vexing one is that the ECB has propped up some struggling banks in the most troubled nations in the Eurozone over the last few years and now these banks have become utterly dependent and its support.

They have been referred to as the "addicted banks" as they have no way to raise additional capital beyond what they can get from the ECB. Presently, the ECB is loaning about $800 billion annually, down from over $1 trillion last year, but 61% of that total is going to banks in four states -- Greece, Ireland, Spain and Portugal -- whose GDP accounts for less than 18% of the Eurozone total. These banks have become a major drag, and there appears to be no good way out of the dilemma. It had been hoped that all this EB support would have been enough to engage the private sector but, thus far, these banks are still financial pariahs.

The banks using these ECB loans to simply sustain liquidity are in the worst shape, and it is not at all clear how this dependency can be altered without collapsing these banks. The ECB wants to end most of these loan programs in 2011, but that may not be possible without some legal manipulation. The fear is that banks that are separated from the others due to their liquidity issues will be sentenced to death, thus creating significant problems in the affected nations. At the moment, the most troubled banks have been able to hide behind the ECB support system with their weakness suspected almost exclusively by the investment community. There assumption exists that they can continue functioning as long as the ECB spigot remains open. However, if the weakest banks are denied full engagement in the auction of these loans, they will lose whatever access to private capital they had, and their demise will be imminent.

If the ECB allows these banks to go under, they solve one issue at the expense of another as this will cripple the banking system in the most economically challenged Eurozone nations. The problem just shifts to another set of institutions, and more pressure is brought on the Eurobond system that has been set up to address the financial crisis in these states. It is a classic Catch-22. If the ECB doesn't do something to fix the banks, the investors will lack the confidence they need to get engaged in these economies, but the only fix available is likely to make the investors more nervous than they are now.

Analysis: There are a host of other issues at play. Some of the latest developments are positive and others more neutral. The most positive news is that the Eurofund established to deal with all this has earned triple-A ratings from all three of the main agencies. Additionally, the European Financial Stability Facility is strong in the event any of these nations have to turn to it for survival. This is very likely in the case of Greece and, to a somewhat lesser extend Portugal and Ireland, which is looking far weaker than in previous assessments. The nearly $1 trillion vehicle is half backed by the European nations and half by the International Monetary Fund. For a while, it appeared the ratings would be less than stellar. It now looks certain that the Germans will play their role, leading to improved confidence in the system.

The other development that will play into all this is the decision to delay the stress tests for the Greek banks. Few expected the majority of them to pass the test, and it seemed to serve no real purpose to impose restrictions that were unlikely to be realistically met. The delay also suggests that conditions are just starting to improve and that given some additional time they may be able to make changes that allow them to squeak past inspection.

Chris Kuehl, NACM Economic Advisor and Co-Founder of Armada Corporate Intelligence

 

 

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