European banking crisis starts to erupt as leaders delay their meeting

Last week the Franco-Belgian bank Dexia became the first bank to fail as the European banking crisis turns deadly serious. Increasingly depositors are worried, with unconfirmed but undenied reports that Siemens just pulled 500 million euros out of Societe Generale for safe keeping with the ECB.

Meantime the 27-strong EU summit has been delayed from October 17 to 23 while officials try to thrash out a plan they can all agree on. The Telegraph today reports that German officials want to raise the losses or so-called haircut on Greek debt from the 21 per cent previously agreed to 60 per cent.

Snow-balling write-offs

This risks a snowball effect as markets will switch their attention to what bigger haircuts would mean for other indebted nations like Portugal, Ireland, Spain and Italy. There could be a run on banks across Europe and the cautious move by Siemens looks a preemptive strike.

The promises from the German and French leaders at the weekend to recapitalize the banks and do everything necessary was vague but rallied bank stocks across the globe.

Yet there does seem to be a complete disconnect between the mounting breakdown in the banking system and wishful thinking by stock markets looking forward to a possible solution that is currently not even on the table.

It is not a question of will the contagion spread but noting that it is already spreading. Effectively Vesuvius has already erupted and the lava is spewing out. Can you really put a plug into such a volcano?

After all the eurozone debt crisis is not a fiction but a reality of numbers that simply do not stack up. It is one thing to organize a default for one country but where does that leave the rest? With impossibly high interest rates and depressionary austerity packages?

Sovereign debts

But the transmission mechanism is of course in the sovereign bonds themselves. If the market reckons the chance of a default increases it lowers the bond price and raises its interest payment by doing so. That means the bonds held against loans are worth less and those loans have to be written down, undermining the bank balance sheets.

This is in a nutshell is where we have gotten to with Greece: is it 21, 40 or 60 per cent that must be written off? The last agreement was for 21 per cent and that still needs to be ratified. In the meantime the markets have chased the value of Greek debt much lower.

Exactly the same thing is now happening to the debt of the other indebted eurozone nations, and the eurozone leadership is responding far too slowly. By the time they can agree on the next solution it will already be insufficient and out-of-date.