Confidence in the structures of European finance is fast disappearing. A bank run in Spain might have catastrophic consequences for the whole system, writes James Meadway

The crisis in Europe spirals downwards. Political uncertainty over Greece now marches in lockstep with creeping financial failure in Spain. Credit rating agency Moody’s last week downgrade 16 Spanish banks in the belief that they are at an increased danger of collapse should a serious run on the banks begin. The Spanish government is now denying that Bankia is suffering from just such run. In Greece, around €700m has been taken daily from the banking system since the inconclusive election on May 6.

Bank runs are an inherent problem for the banking system. Banks create long-term loans, but take deposits on a short-term basis. This is how credit is created – banks, in effect, lend out more money than they actually have available. There’s nothing greatly mysterious about this process, and under normal conditions, the difference between the two does not matter greatly. At any point in time the bank can usually access sufficient reserves to cover all the day-to-day demands made by depositors for their cash. For as long as depositors believe that their depositors are safe, the bank is also safe. A bank run occurs when this confidence evaporates, for whatever reason. Depositors descend on the bank in a panic, demanding the withdrawal of savings for safer locations – another bank, abroad, or simply shoved under the mattress. But while rational for the individual depositors, this panic – a run on the bank – can bring about the very collapse of the bank they are trying to avoid. Worse yet, panic can spread rapidly throughout the system.

The last public run on a UK bank was in November 2007, with queues forming outside Northern Rock as worried depositors attempted to withdraw whatever cash they had access to. To avoid this prospect, governments have developed over the years a number of ways to insulate their banking systems from their inherent instability. Governments offer to act as a lender of last resort, promising to ensure banks always have sufficient liquidity – cash at hand – to meet the demands of their customers. Or they may offer deposit insurance, promising to pay out to depositors in the event of a collapse. Faced with a run on Northern Rock, Alastair Darling, Labour Chancellor of the Exchequer at the time, made a public statement promising the government’s support for the bank. This restored confidence in the bank’s stability, and broke the run. Governments put these backstops in place to try and preserve confidence in the banking system as a whole. If confidence is maintained, banks are less liable to collapse.

Bank runs can be catastrophic. They punctuated the Great Depression of the 1930s, exacerbating the slump, and (arguably) were a primary factor in its cause. The European economy was devastated by the collapse of Austria’s largest bank, Creditanstalt, in May 1931. Creditanstalt had spent the preceding years gobbling up smaller, failing banks, while weakening bank regulation hid its bad loans. When a director finally refused to sign off on the bank’s annual accounts, depositors, believing the bank to be insolvent, rushed to remove their savings. The Austrian government stepped in to guarantee bank deposits, hoping to break the panic. But this guarantee merely undermined confidence in the Austrian state itself. Depositors did not believe the country could afford to both stand behind its banks and maintain Austria’s place in the Gold Standard fixed-currency system. The panic spread beyond Austria’s borders: banks in the Netherlands and Poland collapsed in June, in Germany in July. The fear reached the US and UK by mid-summer. The Great Depression was dragged onwards.

Largely as a result, the regulation of banks was tightened immensely during the Depression and then into the post-war period. Governments have taken on significant new powers in providing support to their banking systems. These measures are in place inside the eurozone. Euro member countries like Spain have said they will support their national banking systems. They are further backed up by the European Central Bank (ECB) which has acted to supply liquidity to both national central banks and banking systems over the last two years of the crisis. In normal times, these reassurances should be enough to break a bank run.

Brewing bank runs, failing firewalls

But these are not normal times. The crash of 2008, and subsequent, sharp recession, revealed just how shaky bank balance sheets had become. The formation of the Eurozone had helped foment an immense credit bubble in southern and peripheral Europe. Countries like Spain, Portugal and Ireland oversaw immense expansions of borrowing, tied in to booming property markets. When the boom collapsed, the dead weight of bad loans was revealed, provoking bank failures. Bank reserves, intended to act as their own backstop against crisis, had dwindled to dangerously low levels, while balance sheets were now stuffed full of bad loans, written during the boom years. Bankia, the Spanish bank now at the centre of crisis, was itself created through a succession of forced mergers with smaller, weaker banks. (Over €1bn was withdrawn from Bankia immediately prior to its hasty nationalisation.) The removal of restrictions on banks’ lending practices, across Europe, had led to an immense over-stretch of credit. It is because depositors now fear the weakness of their banks that the potential for a run is developing.

This is despite assurances of national governments and EU institutions. We are now approaching a second, deeper layer of the crisis in which not only is confidence in national banking systems evaporating, but confidence in the structure of European finance is disappearing. In normal circumstances, the combined reassurances of both the Spanish state and the ECB should be enough to reassure worried depositors. If a run on Spanish banks is now occurring, it can only mean that Spanish savers no longer believe the reassurances of not just the Spanish state – which is in increasingly dire financial straits – but also the ECB itself.

They may well have a point. The so-called “firewalls” against a general European collapse are the temporary European Financial Stability Facility (EFSF) and the permanent European Stability Mechanism (ESM), set to become operational in July. Between them, these two funds are supposed to have around €750bn to supply to governments in financial trouble. That €750bn should be enough to contain and isolate a collapse in Greece, for instance. The theory here is that by supplying sufficient volume of capital to governments, who will in turn use it to prop up their banks, the wider system can be stabilised.

In theory, the sheer volume of cash available through the two institutions should be enough to kill off further crises. In practice, this is not the case. Neither the EFSF nor the ESM actually have this money to hand. The €750bn figure is based on promises to pay by signatory countries – the ESM, for instance, contains only around €80bn in actual funds. A promise to pay, if needed, is not the same as holding actual sums of money: you cannot guarantee that the funds will be forthcoming. In the event of major crisis erupting, there is no way of knowing if either mechanism will be able to supply the cash needed. When those expected to contribute into the EFSF and ESM are also those expecting to receive bailouts, like Spain, it is obvious that neither institution can be relied upon.

In addition, the funding mechanism needed to turn the small amount of capital that both contain into the huge amount theoretically available depends on both receiving high credit ratings; and that, in turn depends on those supplying the cash having a high credit rating. With credit ratings agencies threatening widespread downgrades in the event of a major crash in Europe, this, too, cannot be relied upon.

The fear that these supposed firewalls will collapse is helping to drive the bank runs that are now gathering pace. This is how contagion can spread. If the system cannot credibly ensure the functioning of its banks, it will plunge into a sharp crisis. The aim of the EU, the ECB, and the European powers is  now to try and prevent that collapse through, in the first instance, operations to reassure depositors; or, should that fail, in the second instance to isolate the presumed source of the poison – Greece.

Europe’s debt crisis

Except Greece is not the source of the malaise. This is a general crisis of the European economy, determined by high levels of debt and continuing economic stagnation. If an economy does not grow, it cannot, in aggregate repay its debts – whether public or private. It can attempt to redistribute funds, through austerity, but this further undermines the economy. Or it can attempt to chew away at the debts through persistent inflation above the rate of interest. Absent of those two conditions, and the debt burden is immovable. For Greece, this implies a further default on its public debt. For Spain, it implies extensive defaults – bankruptcies – on its private debt.

The consequences are necessarily unclear. But defaults on a large scale could rapidly push other European banks, who have loaned the cash, into bankruptcy. The solvency of the ECB itself, which has extended significant support to troubled economies, could be put into question. It is not a conventional central bank, backed by a single state able to act as a guarantor of the currency it issues. Because it is the central bank of a multi-member single currency, it is permanently in a weaker position than this.

There are a series of initial steps out of the bedlam. First is to end austerity, which has crippled economies across the continent, from Ireland to Greece. Second is to impose controls on the movement of capital, aiming to block the rapid, destabilising flows of funds that help spread contagion in a panic. These controls can take many forms, whether sharp taxes or special requirements for foreign deposits. Third is to allow defaults to happen, but to manage the process, with governments nationalising failing banks.