A wake up call for Europe

The ECB can be loyal to the mandate granted to it by the Treaty, to maintain its independence from politics, especially the one centered around Germany, and to work to safeguard also the regular market functioning, announcing a policy to stabilize sovereign bond yields of the Countries member of the Union that today, until proven otherwise, are all illiquid, not insolvent.

The more credible the announcement, the more effective the policy is. From this point of view the coordination of the major central banks could allow for a further leap in quality. If each central bank found it compatible with its mandate, also others could buy European sovereign bonds. The Fed could undoubtedly buy them, considering the absolute degree of discretion that its bylaws give it. Incidentally, the Fed also has no problems in buying foreign bonds as long as, like usual, it considers them solvent. For once, the coordination among central banks could make effective that discretion that created and still creates so much damage.
The liquidity crisis is really a deadly toxin: it places at the same level both bad banks, that do not have liquidity because they took on too much risk, and good banks, using as a catalyst the broad and complex relation between them that by now links all banks, regardless of their institutional features, corporate mission and geographic location.

In August, the uncertainty came from the expectations for economic growth; then it went to the sustainability of public accounts and it then spread to the solidity of bank balance sheets. It spread rapidly and deeply because the financial and banking system is the same one that caused the 2007-2009 financial crisis. A financial system that is complex and not transparent in which commercial banks, especially Anglo-Saxon ones, are often intertwined with a shadow banking system.
The fact they are not transparent multiplies the uncertainty and hits the relations between banks, weakening liquidity demand and supply. Each bank increases its risk aversion when it faces two situations: counterparty risk, because it fears that some bank to which it loaned funds to cannot honor its commitments; liquidity risk because it fears that it will not be able to raise funds on the markets, in case of necessity.

In August, there were clear signs of new liquidity tensions, especially when looking at demand for banking reserves in dollars, distinguishing between US and foreign banks (among which European banks). According to Fed data: in October 2008, when the market crisis following the bankruptcy of Lehman Brothers erupted, dollar reserves of US banks were of almost 600 billion, while for foreign banks they exceeded 200 billion. Roughly a year later, reserves of US banks exceeded 800 billion, while those of foreign banks exceeded 300 billion. From that moment, US banks started slowing, while there was growing demand for dollars from foreign banks. The "point of contact" took place in the spring of 2011 at some 750 billion dollars. Overall, between November 2010 and August 2011 the demand for dollars by non-US banks increased by almost 500 billion and that of US banks by some 150 billion dollars.

Therefore a first clue of the rush towards liquidity in dollars by European banks is in US data. A second clue was the initiative the Fed took in August. In those days the Fed publicly announced a program to check the liquidity of European banks in the US. Banking shares crashed as a result and there were further tensions on the interbank market, which was already nervous. It was an irresponsible initiative: systemic tensions on banking liquidity are prevented with coordination and in corporate cases of lack of liquidity they are dealt with in silence. On that occasion, on the other hand, the Fed did not coordinate with anyone, giving an awkward explanation after the fact for its move.

The third clue that the theme of liquidity, probably not just in dollars, of some European banks is relevant comes with the announcement of coordination among central banks.
Better late than never; more importantly, it is too little. Uncertainty is fought off with policies that are systematic, credible and transparent. A double commitment is needed: the immediate one by central banks, with a perimeter that is extended to new players of liquidity, starting from China. But more importantly that from European and US politicians, often ill advised, who continue to not see the enormous risks of a systemic crisis of illiquidity that can continue to arise because the not transparent and badly regulated financial market is the same as the one that generated the crisis.

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