All Eyes on the European Banking Crisis

Over the past several weeks, the European sovereign debt crisis, which had its roots in the global financial and economic crises, is now having a devastating toll on the European Banking system. The situation has become particularly problematic for the French banking system, which has a high exposure to eurozone debt. As Europe seems destined for a full-blown banking crisis, the big question is whether the European Central Bank (ECB) can do enough to prevent the crisis from spiraling out of control.

We believe the European banking crisis has two big elements to it. First, peripheral European countries, including Greece, Portugal and Ireland are on life support because they lack the adequate funds to meet their sovereign debt obligations. Meanwhile, other nations such as Italy and Spain are also having fiscal problems of their own. As these nations struggle to meet their sovereign debt obligations, it is having a ripple effect on the European banking system. The major banks, which purchased a significant amount of these securities, are vulnerable to potential default. In turn, this could affect the willingness of other institutions to do business with them.

The other part of the problem is institutional in nature. While Europe maintains a unified currency (the euro), it lacks a central institution that can enforce a unified fiscal policy like the U.S. (via the Fed). Europe’s equivalent of the Fed—the ECB—lacks the Fed's ability to purchase enough sovereign securities to stabilize the markets (as in QE2), without help from the German central bank, or even to negotiate on its own with Greece and other troubled countries. Each individual country is responsible for its own fiscal policy. The ECB and other pan European financial leaders need the cooperation of the individual countries to undertake extraordinary financial measures. This has slowed down efforts to reach a resolution.

What is getting in the way of controlling the crisis is decision making. There are some things that can be done to control the crisis like restructuring Greek debt or even allowing a default, as well as working with countries like Italy to prevent the crisis from getting worse. However, the ECB is having a tough go at getting nations in the eurozone to agree to a unified solution, so the debate lingers on as to what should be done.

The big question on many investors’ minds is whether the European banking crisis can spread to other countries around the globe, including the U.S. While it certainly can be contagious, we believe that this is not the likely scenario. Germany and France, which are the two strongest eurozone countries, believe they must do what is necessary to head off a general disintegration and are working to get consensus within their countries and across other countries on a solution. Indeed, the French government will have to step in to support its banks that are deemed to big to fail, much as the U.S. government did during the financial crisis in 2008.

In the long-run, the question is whether the experience of the current crisis will spark the creation of stronger central institutions in Europe that have the authority and capacity to devise and implement pan eurozone fiscal and monetary policies sufficient to prevent similar crises in the future. There is some evidence, such as the creation of a centralized lending authority separate from the ECB, that this is beginning to happen.

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© 2014 and prior years, Teachers Insurance and Annuity Association - College Retirement Equities Fund (TIAA-CREF), New York, NY 10017