We are currently experiencing a sea change in the financial environment, moving from very low to much higher inflation levels and from a low/negative interest rate to higher levels.

This puts the European Central Bank between the proverbial rock and hard place. It has unenviable options: it can leave interest rates low, in which case inflation will likely worsen, or it may raise interest rates to curtail inflation, which could trigger a wave of defaults for highly leveraged governments, corporations and individuals, ushering in a recession or depression.

European bond yields have shot up considerably over the past weeks but have much farther to go if the intent of the ECB is truly to curtail inflation. For this to happen, government bond interest rates in more developed countries such as Germany, currently close to 0%, would need to move higher than the inflation rate (currently at around 5%, according to official statistics in the Eurozone, and still rising). Bond yields in peripheral countries such as Greece are skyrocketing as of the beginning of February 2022, already approaching 3%.

I have argued in previous articles that the U.S. Fed is unlikely to raise interest rates to curtail inflation; for the ECB, this would be even more difficult. It simply cannot afford to trigger a wave of defaults in an economic environment that has been more anemic than in America. 

Inflate Away

The current negative real interest rate environment does, however, create an opportunity: to inflate away the national debt. Although inflation amounts to a form of legal theft against savers (whose savings will not keep up with inflation, hence the term “financial repression”), inflating the debt away seems to be the lesser of evils when compared to raising interest rates, triggering defaults, and a recession or depression.

A by-product of financial repression will involve adverse effects on European banks. We will take a quick overview of the recent condition of European banks and then speculate on how an inflationary, financial repressive environment may affect them.

European banks were typically much slower to write off bad loans and work out their bad debt portfolios than U.S. banks. They also have lower returns on equity. It does not help that macroprudential regulation has encouraged European banks to load up with large amounts of negative-yielding government debt as a means of helping governments finance their deficits. Hence, European banks have difficulty accumulating retained earnings that might help them withstand a future crisis; and must dilute ownership considerably should they need to raise additional capital.

Sociéte Générale, perhaps the weakest G-SIB (Globally Systemically Important Bank) in Europe, according to a recent analyst report by Saxo Bank, has a market capitalization under EUR 10 billion, trades at only 17% of its book value, and has a less than 15% Tier 1 ratio (reflecting leverage and the percentage of capital available to withstand losses). Its expected return on equity over the next two years is less than 4%.

Other European G-SIBS, such as Deutsche Bank and Commerzbank, have marginally higher Tier 1 ratios but even lower expected ROE. (In fairness, the Tier 1 ratios are higher than during the 2009-2011 crisis). Deutsche Bank’s share price fell from EUR 100 in 2007 to EUR 13 in 2022. It also has considerable exposure to derivatives.

(Warren Buffet, you may recall, called them “weapons of mass destruction.” Because of inadequate disclosure requirements, it remains difficult to ascertain the precise level of derivative exposure of banks. Such uncertainty can be extremely dangerous in times of crisis, as it was during 2009-2011.)

Significant Loses

Rising bond yields in Europe could result in significant losses for banks holding government bonds, suddenly reducing Tier 1 ratios. This was also at the heart of the 2011 European banking crisis.

While certain European G-SIBS have limited ability to withstand a major financial crisis, there are also risks with Europe’s non-globally systematically important banks and non-bank financial institutions. The latter constitute about 40% of financial assets in Europe, are barely regulated, and are highly pro-cyclical.

The International Monetary Fund has stated that the weakest spot of the global financial system is likely European banks.

A default by a European G-SIB would send shock waves around the world. Remember, this is in the context of global debt having reached astronomic portions: 355% of global GDP. It would also likely trigger an immediate explosion of risk premia on highly indebted/low growth countries like Italy and Greece. The ECB had enough trouble to keep Greece from going off the rails; if it were necessary to rescue a major nation such as Italy, that could be a shock of sufficient magnitude to trigger the demise of the Euro, perhaps even the European Union itself.

Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.

This article was first published in the Budapest Business Journal print issue of February 11, 2022.