THE ECB IS DISQUALIFIED BY THE CALL FOR A NEW STATE AID Final sprint in the race of bank defaults in Europe?

In a banking system built on the foundation of money being created by banks through granting loans and fractional reserves, insolvency is the natural state of things.

In this context, the confidence of the depositors and the guarantees granted by the state, along with the permanent support of the central banks, represent essential conditions for the functioning of financial institutions.

"The truth about banks" is the title of an article from the Finance & Development magazine of the IMF (author's note vol. 53, no. 1, March 2016), in which the authors, Michael Kumhof and Zoltan Jakab, write that "banks create new money when they grant loans, a phenomenon which can start and exacerbate financial crises".

Creating money out of thin air represents "a critical vulnerability of financial systems" for two reasons which have been known at least since the time of the Great Depression in the first half of the 20th century. First of all, "if banks are free to create money when they grant loans, then that amplifies the potential to create cyclical booms and busts, especially when banks mistakenly assess the debtors' repayment ability", according to the economists of the IMF.

The massive volume of non-performing loans that still exist in Europe, of approximately 900 billion Euros, show that the mistaken "assessment" of the repayment ability was endemic, and the risk models were useless.

Second of all, "creating money through lending creates a permanent connection between money and lending, which becomes problematic when the high level of debts can start a financial crisis".

Such a financial crisis represents the reality of the last few years in Europe, and the fiscal and monetary authorities in Europe are afraid to tackle the real causes, instead opting to focus on mitigating the effects.

In this context, a new acute phase of the banking crisis has begun not just on the outskirts of the Eurozone, but also in the continent's most powerful economy, Germany.

Stock prices of Italian banks have seen massive drops over the last few weeks, amid chronic undercapitalization and the massive portfolios of non-performing loans.

When the ECB asked the bank Monte dei Paschi, the third largest in Italy in terms of assets and the oldest bank in the world, to reduce the volume of its non-performing loans by 40%, in the next three years, the downward spiral of its shares has escalated and has caused the authorities to suspend short selling until the beginning of October 2016.

Zerohedge has commented ironically the decision of the Italian authorities, as they "forgot" to also ban the buying of CDS contracts (author's note: Credit Default Swap) for protection against default. The latest CDS quotations for Monte dei Paschi (author's note: symbol: BMPS) indicate a 63% probability of default, according to data from Bloomberg.

In the second half of the last decade, before the beginning of the global financial crisis, the adjusted value of the BMPS shares has doubled, passing 100 Euros, and then fell over 5-fold. Since the beginning of the year, the stock market "monitor" of the oldest bank indicates clinical death.

"The banking crisis in Italy can spread to the rest of Europe, and the regulations that limit the creditors' assistance by the state need to be reconsidered", said Lorenzo Bini Smaghi, the president of Societe Generale and former high ranking official of the ECB, in an interview granted to Bloomberg.

But how far will this aid go, and who will bear the costs? Unfortunately for commercial and central bankers in Europe, the continental banking system is deeply unstable, some would even say deeply bankrupt, even without the additional pressure coming from the Italian banking system.

Bloomberg recently wrote that aside from the low interest rates, the massive volume of non-performing loans, or the competition from FinTech companies (author's note: companies that use the new technologies to increase the efficiency of financial services), one of the main issues of the European banking sector is represented by the avalanche of new regulations.

Is that true? The Basel II agreement was published in 2004 and its implementation began ahead of 2008, but it hasn't prevented the occurrence of the global financial crisis. In fact, the regulatory framework represents more of a barrier to entry on the banking market, due to the massive compliance costs, and a means of "protecting" the already existing players.

Furthermore, the regulatory framework, especially the one dedicated to capital adequacy, has created a false feeling of safety when it comes to the safety and solvency of European banks, as a result of the "discretionary" use of risk weights to determine the risk-weighted assets, especially in the case of the evaluation methodology based on internal models.

Gripped by panic, the Italian authorities have put forward the option of the recapitalization of banks by 40 billion Euros, but the opposition of European authorities, especially the German ones, was immediate. The option of indirect support through government guarantees of 150 billion Euros was later discussed.

All of these proposals however, do not comply with the European regulations on state aid, as officials of the Renzi cabinet have notified Italy's intention not to comply with the European banking resolution framework, where a new bail-out cannot take place ahead of a bail-in.

Opinion on Bloomberg and Financial Times show that European banking regulations must be made more lax, or else there is a major risk of Italy exiting the EU.

Article 32 of the Banking Recovery and Resolution Directive stipulates, however, "the option of extraordinary public aid to avoid or remedy a grave disruption of the economy of a member state and to preserve financial stability", but the support may only be granted to solvent banks and has to comply with the European regulations concerning state aid.

Faced with Germany's opposition, prime-minister Renzi went on the offensive and stated that "Italian banks represent a smaller problem than some banks' derivative portfolios", according to an article from the Financial Times.

Most market opinions think that the target of Renzi's attack was the Deutsche Bank group, whose portfolio of derivatives, of over 50 trillion Euros, has caused the IMF to view the biggest German bank in Germany as "the main source of the global systemic risk".

With a leverage ratio far higher than the one of Lehman Brothers before the collapse and involved in about 7,000 lawsuits, DB has an acute need of additional capital, but investors aren't interested.

This is the context in which Vítor Constancio, the vice-president of the ECB has stated, in a speech in Madrid, that "the situation calls for deep reflection concerning the covering of market defaults through small-scale public aid, so that the stability of banking systems is improved". Constancio also showed that between 2008 and 2014, financial aid granted to the financial sector has amounted to 8% of the Eurozone GDP, of which approximately 3% has been recovered.

It seems the ECB official considers it a market failure that the banks cannot afford to reduce their exposures and their leverage rate by selling some assets from their portfolios. The justification used in the unacceptable delay of the process to clean up of the balance sheets is that of "unfair" parents. But how have these prices come up? Was it not precisely through the central banks disregarding the "inflation" of financial assets, stimulated by the lax and ultra-lax monetary policies over the last decades?

After the countless institutions and committees created on a European level, but also at the level of the EU member states, to ensure financial stability, why is the ECB bringing back the issue of state aid for banks?

Doesn't this automatically discredit the central bank in the Eurozone as overseer of the banks of systemic importance?

A day after the statements of the ECB officials, it was the turn of the governor of the Bank of Italy, Ignazio Visco, to mention that "in times of high uncertainty, the intervention of the state cannot be ruled out", because there is a risk of confidence in the banking system decreasing, as Financial Times writes.

The questioning of the application of the European banking resolution framework, just a few months after its coming into effect, shows that indeed, the situation of the banking system in Europe is much more dire than the authorities will admit.

Nevertheless, it is quite unlikely we will see defaults, in the classic sense of the word, among banks of systemic importance, but the escalation of the tensions between the governments of the Eurozone and the "separatist" tendencies is very likely.

Until the market is allowed to function and to "clean up" the bank balance sheets, the European crisis will continue, despite the states' interventions, because it is increasingly clear that the printing press of the ECB will not help with financial stabilization and does not resolve the problem of the banks' solvency.

Any other "solution" does nothing but impose unbearable costs on European citizens and transform the resumption of economic growth into an impossible dream.