Crisis lingers as a new reality has dawned

At their Brussels summit last week, European leaders were able to agree on a fiscal union. But on the market front the jury is still out with indications that those who were hoping for eminent stability will be disappointed because a major crisis in the continent’s banking sector might be much closer than many realise. It probably has signaled the beginning a new European-, and wider, geopolitical reality.

The new pact, championed by Germany’s chancellor Merkel and French president Nicolas Sarkozy holds much promise for a more united Europe that is better positioned to avoid a future repeat of the present financial crisis. It also, however, has a number of crucial flaws:

Firstly, the pact ducked all the big fiscal decisions such as debt pooling or some sort of centralised EU Treasury. Neither is there a banking licence for the so-called “permanent” rescue fund – the European Stability Mechanism (ESM) – that is planned to displace the European Financial Stability Facility (EFSF). Nor, for that matter, was there any change of mandate for the European Central Bank to allow the bond-buying blitz that could rescue bombed-out sovereign states that the  bank's president, Mario Draghi, claims he cannot legally sanction.

Secondly Britain is not on board and the European Union might be able to function quite as well as it would need to without Britain.

Banking crisis

Richard McGuire, senior fixed income strategist at Rabobank warned over the weekend  that the so-called peripheral sovereign crisis is actually a core banking crisis in disguise. He highlighted the fact in light of the exposure of France’s banks in particular to Portugal, Italy, Ireland, Greece and Spain. The £483bn exposure equates to 24.3% of France’s GDP. Similar exposure of UK banks (mainly to Ireland) is equivalent to 14.4% of GDP. For Germany it is 14.7%.

Not only that, but just as crucial, says McGuire, is the exposure that Europe’s banks have to France’s banks. The exposure of Dutch lenders, for example, is equivalent to 10.1% of the GDP of The Netherlands, while for Britain’s banks the figure is 12.2%.

The eurozone banking system is on the edge of collapse as major lenders begin to run out of the assets they need to keep vital funding lines open.

Senior analysts and traders warned of impending bank failures as a summit intended to solve the European crisis failed to deliver a solution that eased concerns over bank funding. The European Central Bank admitted it had held meetings about providing emergency funding to the region's struggling banks, however City figures said a "collateral crunch" was looming.

"If anyone thinks things are getting better then they simply don't understand how severe the problems are. I think a major bank could fail within weeks," said one London-based executive at a major global bank.

Many banks, including some French, Italian and Spanish lenders, have already run out of many of the acceptable forms of collateral such as US Treasuries and other liquid securities used to finance short-term loans and have been forced to resort to lending out their gold reserves to maintain access to dollar funding. "The system is creaking. There is a large amount of stress," said Anthony Peters, a strategist at Swissinvest, pointing to soaring interbank lending rates.

The results of the fourth round of European Banking Authority (EBA) stress tests conducted in just under 18 months pointed to a €115bn capital shortfall in the eurozone financial system, with German banks showing the most notable deterioration in their core capital ratios.

Moody's, on Friday, downgraded France's three largest banks, BNP Paribas, Credit Agricole and Société Générale in light of what the US rating agency said were "liquidity and funding constraints".

Britain’s position

In an opinion piece over the weekend for The Telegraph, Roland Nelles wrote: “The euro crisis has exposed a kind of creative momentum that is in the process of creating something new. A new Europe. It is an entity which Chancellor Angela Merkel calls a "fiscal union." But in reality, Europe is on the path toward becoming a federal country. Germany and France would lead, as became clear on Thursday night in Brussels. But leaders must also ensure that all are included. Arrogant posturing aimed at appeasing the electorate back home is damaging.

“That is true of relations between large and small EU member states. But it is also true of relations with Great Britain. The preferred outcome is clear -- of course Great Britain should become part of an integrated euro-Europe. Merkel and French President Nicolas Sarkozy should clearly say so.

Europe, though, can work fine without the British. But what kind of future does Great Britain have without the Continent and without the euro? Will it, in the future, focus exclusively on its alliance with the United States? Will the Commonwealth become a greater priority? What is this small country's role in a world made up great powers such as China, Russia, Europe and the US?

These are the questions that Britain must now answer. And it doesn't have much time. If the Brits wait too long, history will simply move on. Should that happen, it would be bye bye Britain."

In Der Spiegel Carsten Volkery wrote that the summit's outcome will seal the status of a two-speed Europe. Back home, Cameron is already being accused of driving his country into isolation.

In fact, Britain’s governing coalition has immediately shown some strain in the wake of prime minister Cameron’s decision to go his own way at the summit. Nick Clegg, the Deputy Prime Minister, has warned that David Cameron's decision to opt out of Europe is "bad for Britain", revealing a deep split in the country's coalition government.

Market reaction

Questions have also already been raised over whether the construct of the new fiscal union can be legally reconciled with the Lisbon Treaty, which defines the governance of the EU and will still remain binding.

But as Volkery pointed out, from the perspective of the financial markets, the dispute over the treaty amendment is a mere sideshow. They are only interested in the question of how the firepower of the euro backstop fund can be boosted and what role the European Central Bank will play in combating the crisis. On this front, European leaders have made little progress.

If anyone had been hoping for a quick solution to Europe's problems, it looks like they will be disappointed. Clearly more turmoil lies ahead.