August 6, 2012
Last week Mario Draghi, president of the European Central Bank, issued an indirect challenge to banks by firmly committing the ECB to eliminating risk premia reflecting “convertibility risk” – the fear that the euro might disintegrate into smaller currencies. The scale of that task is clear from how banks are not only limiting new lending to stressed eurozone countries, but – as US banks are reported to do – tweaking derivatives contracts to protect their claims in case of a euro break-up.
Prevarication by the eurozone’s elected leaders has transformed an exit from the single currency into a live if unlikely policy option. The risk managers of banks would be remiss if they did not make contingency plans for such an eventuality. After all, they failed to foresee the unsustainability of the US mortgage market – the cause of the crisis.
But what is individually rational for any prudent bank, collectively risks bringing closer the danger each is trying to avoid. The eurozone financial market is unravelling: cross-border interbank lending has dried up with banks now collateralising their assets for ECB liquidity. The resulting credit starvation in countries such as Spain and the uncertainty caused by legal manoeuvring of banks’ derivatives exposure can only make the recession in the eurozone worse.