Irish Bailout Is a Backdoor Bailout of European Banking System

This is an article that was blogged by Larry Doyle a Wall Street veteran.

What is going on in Ireland? Those forty shades of green look so inviting. How could it be that the Emerald Isle is the center of the current financial turmoil? Well it is…and it isn’t.

How is it that a variety of Irish officials can claim that they neither need nor want a bailout from the EU but a bailout is assuredly on the way? Are we witnessing a sovereign nation losing the ability to control its own affairs? There is no doubt the Irish are a proud people but are they also being overly stubborn at this juncture (believe me, I know proud and stubborn…!!)? Are the Irish failing to accept the inevitable? Hadn’t the Irish attempted a Swedish style approach in terms of aggressively recognizing losses within their financial sector?

While the answer to all of these questions is a varying degree of the affirmative (especially the proud and stubborn..!!), to truly understand what is happening in Ireland, we actually need to shift our focus to the European mainland. Really? Why’s that? Let’s navigate the tangled web and interconnectedness of the global banking system circa 2010.

The ‘bailout’ structured as a loan that the European Union is close to forcing the Irish government to swallow has as much to do with banking on the continent as it does with the banks in Ireland. While I have yet to see any major media outlets fully explore and expose this reality, on October 19th The Economist Intelligence Unit did just that in writing, France/Europe Economy: Feeling Exposed?:

Two recent reports have highlighted the extent of French banks’ exposure to the sovereign debt of risky peripheral euro area countries, which is far larger than implied by the European stress tests conducted earlier this year. French banks are the most heavily invested in Greek sovereign debt, and also have considerable holdings of Irish, Portuguese and Spanish public- and private-sector debt. Regional bailout facilities in place to support struggling euro area countries have reduced the risk of another near-term financial shock, but the interconnectedness of the larger European banks and their exposure to the weaker member states suggest that liquidity, and possibly solvency, concerns could emerge should the sovereign debt crisis take a sudden turn for the worse.

Lot of good those European bank stress tests did us, heh? Yes, those were a joke. In regard to a sovereign debt crisis, well it took not even a month from the time of The Economist’s report for that ‘turn for the worse’ to be upon us. Let’s navigate further into this web.

Market participants will be aware, however, that the unfolding sovereign debt crisis across the euro area still has a long way to run.
You think? Understatement of the year!!

Despite substantial official bailouts (and the prospect of additional support in the future), sovereign borrowing in peripheral euro area countries remains under enormous strain, as international investors balk at a combination of unsustainably large fiscal deficits, highly indebted private sectors, significant crossborder banking exposures, and structural competitiveness issues that will weigh on economic activity for years to come.

This statement is also known as ‘the new normal.’ If the author inserted California for ‘peripheral euro area countries,’ the author may have just defined the economic reality here in the United States as well.

This, in turn, explains investors’ continued focus on the perceived health of the euro area banking sector, which remains under close scrutiny despite most of the region’s financial institutions receiving an apparent clean bill of health in Europe-wide bank stress tests conducted by the Committee of European Banking Supervisors (CEBS) in July. Since then, the rigour of the stress tests has been called into question on a number of occasions, most recently by an Irish MEP (member of the Europe Parliament), Alan Kelly, who has requested an explanation from officials as to how Allied Irish Bank was deemed to be sufficiently robust to pass the tests only a few months before Irish taxpayers were forced to step in with a €3bn capital injection.

My, oh my! Once again, investors get fed a healthy dose of ‘garbage in, garbage out’ in terms of the rigor of bank stress tests. (I highlighted as much in a Bloomberg Businessweek debate this past June 17th, Sense on Cents Enters The Debate Room).
A closer examination of institutions’ balance sheets would suggest that the underlying fragility of the European banking sector continues to harbour a number of risks to the cohesion of the euro area. One such risk reflects the significant share of sovereign debt of peripheral “deficit” countries that is held by banks in the “core” countries, primarily France and Germany. Indeed, the need to limit damage to the France-German banking sectors was one of the driving factors in establishing the EFSF (European Financial Stability Fund).

BINGO!!! There is your answer as to why the French and Germans are force feeding this loan down the Irish throat.

Given the regional rescue facilities now in place, another major financial shock appears unlikely in the near term.

The Economist Intelligence Unit report is fabulous, but they missed this call.
….given the substantial exposure of core EU countries’ banks to the struggling euro area periphery, the complex web of crossborder linkages, and the uncertain outlook for many developed economies as fiscal austerity starts to bite, policymakers would be wise not to downplay the risks to the region’s banking sector should the sovereign debt crisis take a sudden turn for the worse.

Like now. But what happens when the dominoes wobbling in the other PIIGS (Portugal, Italy, Greece, Spain) start to topple even further?