This week has seen increasing pressure on the sovereign debt markets of all Euro-zone countries save Germany.  This broadening of market pressure to Euro-zone countries other than the PIIGS cannot be entirely ascribed to worries about budget deficits in core Euro-zone countries.

Several Euro-zone banks have disclosed in recent results announcements that they have been selling sovereign debt at a loss and it is this, coupled with the general nervousness of the markets at the moment, which is driving sovereign yields higher.  The European Banking Authority (EBA) has fueled the panic by announcing on 26th October that banks will now have to have Core Tier 1 capital of 9% after marking their portfolios of sovereign debt to market prices.

Let’s use a simplified example.  Banca de Piazza (BdP) has Core Tier 1 capital of €7 bln with €100 bln of Risk-Weighted Assets (a €100 bln mortgage book and €50 bln of loans to corporates).  In addition it owns €50 bln of Italian government bonds (BTPs).  When the EBA first required banks to have Core Tier 1 ratios of 9%, BdP needed to raise €2 bln in capital by 30 June 2012.  However by the close tonight its BTPs had fallen by 5% in price – now it needs to raise €4.5 bln and if BTPs fall another 5% next week then it will need to raise €7 bln by the middle of next year.  This is the death spiral in action.  Note that our imaginary BdP bank has gross leverage of 28x whereas many European banks are leveraged 40x.

The banks worked this out the minute the EBA made its announcement and they have been selling sovereign debt as fast as they can before it falls any further in price.  But we have the age-old problem of everyone wanting to sell at the same time and they can’t all get out.  Selling sovereign bonds at a loss does nothing to reduce their RWAs because government debt is zero-weighted but the loss generated does reduce their Core Tier 1 capital.  Multiply this problem across the entire Euro-zone banking system and the ECB has a fast-developing banking meltdown on its hands.  Three weeks ago the EBA reckoned the banks needed to raise €106 bln in fresh capital, following the sell-off in Euro-zone sovereign debt since then that number is a lot higher tonight.

This is now a solvency problem and not a liquidity problem which the ECB has solved in the past by lending freely against any old assets which banks could pledge in return. This situation cannot and will not be allowed to persist for much longer.  The ECB cannot allow the Euro-zone banking system to implode.  Either the EBA will do another U-turn and allow banks to mark their non-Greek government bonds at par (never mind what price they are trading at) or the ECB will have to act dramatically (e.g. backstop Euro-zone sovereign debt, lend to the EFSF, lend to the IMF, etc.).  There is a precedent for the EBA’s U-turn option – the Fed allowed US banks to mark their dodgy Latin American loans at par for years until the US banks were in a fit state to begin to recognise their LatAm losses (led by Citibank in 1987).

What started as a flawed assumption (that Euro-zone sovereign debt would always be repaid at par and was therefore “risk-free” and thus granted a zero risk weighting in banks’ capital ratio calculations) has now morphed, via a hasty rule-change from the EBA last month, into a full-blown banking crisis across the Euro-zone. Non-German governments are powerless to bail out their banks because they would have to fund those bail-outs by selling yet more sovereign debt that nobody currently wants to buy.  The EFSF can’t fund the bail-outs because it would have to sell bonds to buyers who are not at all sure what the entity they are lending to will look like in a few years time.  And the ECB doesn’t want to backstop sovereign bond markets because Draghi has said “that is not in our remit”.  And Merkel won’t let the ECB lend the EFSF money to allow the EFSF to do its job (which, after all, is supposed to be lending to governments, buying their debt in the secondary markets and re-capitalising banks).  Something is going to have to give.

Post-Script:  8 Dec 2011.  The EBA has now realised it was hindering rather than helping and has tonight executed a partial U-turn by stating that sovereign bond prices as at 30 Sep 2011 will be used and this will not be revised (no matter how far bond prices fall).  They are also trying to stop the rot in sovereign bond prices by highlighting in their announcement that sales of sovereign bonds by banks will not reduce the amount of capital to be raised.  The EU has also belatedly realised that requiring private sector bondholders to take bigger losses on sovereign bonds simply will not work and the EU has now ditched this terrible idea – EU President van Rompuy said “To put it more bluntly: our first approach to private sector involvement, which had a very negative effect on the debt markets, is now over”.  Europe’s politicians seem to be rather slow in learning that the bond markets are their masters – the American James Carville could have told them for free.