In a shocking turn of events last week, Kweku Adoboli, a 31-year-old equities trader at Swiss bank UBS, engaged in reckless trading that led to a staggering loss of $2 billion of client funds. UBS uncovered a significant discrepancy in its trading records on Wednesday night, resulting in Adoboli’s arrest the very next morning. While this incident is troubling on its own, it serves as a powerful illustration of the challenges currently facing European banking.
As many are aware, Greece is in a dire financial situation, struggling to stabilize despite multiple bailouts from the European Union. This predicament stems from the Greek government making excessive promises and borrowing beyond its means for far too long. Indeed, Greece has acted with carelessness.
However, the fault does not lie solely with the Greek government. European banks are also guilty of irresponsibly extending credit to Greece, compounding the crisis. They too displayed a lack of prudence.
Why did these banks lend such substantial amounts to Greece? What motivated them to endanger their finances and those of the entire European banking system by issuing numerous dubious loans?
Adoboli might have insights into these questions, but that won’t stop us from exploring further.
Guided by Moral Hazard
Across Europe, banks are operating with a troubling leverage ratio of over 30 to 1, meaning they have 30 euros in loans for every euro of actual capital. This alarming statistic indicates that if their investments suffer just a 3 percent decline, their capital would vanish.
Clearly, European bankers pursued profits with a reckless greed. When it came to sovereign debts, they acted under the assumption that the risks were negligible. They provided loans to governments as though there was no possibility of default.
The underlying belief was that, in times of crisis, the European Union would step in to bail out the at-risk country. Furthermore, if the EU hesitated, the European Central Bank would rescue the “too big to fail” banks at risk of insolvency.
We have little doubt that these bankers are shrewd operators, fully aware of their actions… or are they?
One of the intriguing aspects of current global finance is the rapid succession of crises. This week could reveal whether the convictions held by European bankers stand the test of reality.
Once again, we can thank Greece for making this situation possible.
Magnifying a Magnificent Debt Bubble
Greece’s GDP constitutes less than 2 percent of the entire European Union economy. In the grand scheme, its economic output is almost negligible. Yet, within the context of the EU, it may very well be the straw that breaks the camel’s back.
The ideal resolution to a nation’s insolvency is default. This process clears away bad debts and serves as a lesson to both lenders and borrowers alike. Lenders learn to be more discerning, while the defaulting nation is compelled to live within its means. Yet, inexplicably, those in power are willing to go to great lengths to avoid a default.
So far, Greece has been given multiple opportunities to rectify its situation, receiving financial assistance in exchange for commitments to reduce spending. However, it has continuously failed to meet these obligations, taking bailout funds only to request more. Meanwhile, banks have been given a pass for their poor lending decisions.
Understandably, citizens in more productive nations, such as Germany, are growing weary of their hard-earned money being funneled into Greece’s financial issues. If Germany were to refuse additional bailouts, European banks could find themselves exposed and potentially insolvent—echoing the collapse of Lehman Brothers just three years ago.
Yet, central bankers worldwide are determined to prevent such an outcome. Recently, the European Central Bank, together with the U.S. Federal Reserve, Bank of England, Bank of Japan, and Swiss National Bank, announced the provision of three-month dollar loans to Europe’s commercial banks.
However, this measure does little to resolve the underlying issues. Bad debts do not simply vanish—they become a part of the balance sheets of these central banks. Furthermore, how do these central banks fund these loans to European banks?
That’s the crux of the matter. They create money from thin air. This influx of digital monetary credits into banks only perpetuates the problem, inflating an already precarious debt bubble. When this bubble bursts, the consequences will be catastrophic.
Sincerely,
MN Gordon
for Economic Prism
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