A failure by European regulators to make banks raise enough capital to withstand a sovereign default is complicating efforts to resolve Greeces debt crisis.
It's not a failure - it was an intentional act.
By allowing banks to run at unsound capital levels the "earnings" of those institutions are greatly magnified. If a bank earns a 3% spread on its lending the difference between being levered 10 times and 30 times is a two hundred percent increase in reported "earnings."
The problem is that lending against non-existent collateral (e.g. lending money to a nation that has no possibility of paying) is identical to lending against nothing. It's even worse when you have the ECB taking those bonds that will default and repoing them at face value, allowing the compounding of leverage upon bogus leverage.
While estimates of the capital shortfall vary, the vulnerability of European banks to a sovereign shock isnt disputed. Independent Credit View, a Swiss rating company that predicted Irelands banks would need another bailout last year, found in a study to be published tomorrow that 33 of Europes biggest banks would need $347 billion of additional capital by the end of 2012 to boost their tangible common equity to 10 percent, even before any sovereign default.
So why hasn't it happened? And, incidentally, where are you going to get $347 billion in additional capital?
Greece should tell the EU and ECB to screw off. They have the clear upper hand here, and there's no reason for them to put up with this crap. It is absolutely true that they need to stop spending more than they make, and imposing that discipline through a default (which will make future borrowing either extremely expensive or impossible) is an excellent way to do exactly that.
But: At the same time, Greece must force those who inappropriately lent to take their lumps. Market discipline is vitally important to proper intermediate and long term financial stability, and restoring it is now in Greece's hands.
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