One lesson we have learned during the financial crisis is that a country’s banking system is an indirect liability of the sovereign.  That is, unless the government is willing to allow banks to fail and let the domestic financial sector collapse.  We define failure here as depositors, CD holders, etc, losing or having their savings frozen.  This is very different from the bank failures in the U.S., for example, where the government through the FDIC closes banks with no disruption to the deposit base.

Early in the crisis, the ECB put pressure on the Irish government to backstop its banking sector in order to prevent a run and financial collapse.  Irish banks, still on life support and in need of liquidity to fund a deteriorating balance sheet, continued to draw massive amounts of funding from the ECB.   These bank liabilities to the ECB are now effectively the liabilities of the Irish government.

Spain is in a similar situation, where the government’s sovereign liabilities look manageable but is drowning in explicit, implicit, or the  expected backstopping and  a weak financial  system.  Kenneth Rogoff, professor at Harvard University, and was formerly chief economist at the IMF, writes,

Spain is a more difficult case. The central government is arguably solvent, but a significant chunk of municipal and provincial bank debt seems underwater. The big question in Spain is whether, as in Ireland, the central government will allow itself to be gamed into taking on private (and also municipal) debt. Here again, history gives no cause for optimism. It is very difficult for a central government to sit on the sidelines when the economy’s key players are on the brink of collapse.

Backstopping the banking system without access to a printing press or central bank has proven to be a disaster. Imagine if the State of California were to backstop the liabilities of its banks, for example.

The destabilizing feedback loop of deteriorating sovereign fundamentals due to explicit/implicit bank guarantees, coupled with the”lack of a lender of last resort” to the financial system, is extremely difficult to address as the Eurozone is now finding out.

The upshot?   Don’t bank on the sovereign analysis of analysts who cover overbanked countries without a central bank.

Related Articles
Germany Stiffens Opposition to Bigger Bailout in Crisis Face-Off With ECB – Bloomberg Disagreement over EU debt crisis measures deepens – AP
The Euro at Mid-Crisis – Ken Rogoff