June 17, 2016

Brexit: All Eyes On European Banks

No One is Discussing the Real Issue

Those in the “leave” or “Brexit” camp are in the headlines citing a long list of understandable issues:  economic underachievement, immigration, lack of transparent democratic processes; frustration with challenges seemingly beyond the control of local governments. They fail, however, to mention the real issue that is a risk to today’s financial markets. 

The real issue should be known to Europe’s politicians and especially understood by its central bankers.   The real issue is debt and how its tentacles spread throughout Europe and indeed the world.  The Euro as a currency is not just flawed; it’s also the financial equivalent of a thermonuclear debt bomb.  Its many and terrible design failures make it dangerous.  Its designers and defenders either don’t want to acknowledge its shortcomings or, even worse, are simply unaware of them.  Let us explain.

Europe’s banks are bigger, more leveraged, and more indebted than U.S. banks.  This means a smaller cushion to guard against unexpected losses.  Furthermore, the EU’s fragile financial system of massively overleveraged banks is choking on cross-border liabilities from other banks in a way that almost no one can truly quantify and even fewer understand.  Further complicating this issue, the governments that have borrowed in Euros are not free to print Euros to backstop their own banks.  Our concern is that this terrible flaw could spread far beyond the limited and understandable issues that divide Britain’s voters.  As we have argued many times (“Is Spain the Next Greece?” June 1st 2016), those countries with currencies pegged to the Euro are most at risk from its design flaws – Spain, Italy, and France, just to name a few.  But the debts of these countries’ banks to other banks, and frankly the debts of those banks to others, create the preconditions of systemic weakness not seen since the days after Lehman Brothers failed.

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