Well, punk, do you feel lucky today?

The negotiations for a second bailout of Greece are going to the wire.  Indeed, the goal line seems to be reset further back as some EU countries are wondering whether a Greek default would be less costly than the funds they are supposed to come up with to avoid it.

In retrospect, both the IMF and the Eurozone probably rushed into the first bailout, and the question now is whether they would be throwing good money after bad.

Initially, the ECB committed €45 billion and the IMF together with EU countries and other institutions another €65 billion. In total, €74 billion were disbursed.

What is under consideration now is another €93.7 billion from the EFSF to be applied as follows: €30 billion to help Greece finance part of the private debt restructuring/buyback; €35 billion to help Greece finance the buyback of ECB financing; €5.7 billion to help Greece pay accrued interest; and €23 billion to recapitalize Greek banks.  Net net, the IMF/ECB/EU exposure to Greece would rise to €132.7 billion.

As the clock is about to strike midnight, the wealthier European countries seem to feel like the “punk”, wondering if he should take a chance and reach for his gun, or back off should Dirty Harry have one more bullet in his Magnum .357. “Well, […], do you feel lucky today?”

The key variable in this equation is Italy.  Back in the summer of 2011, markets put Italy and Greece in the same bag, and given the size of the former, a default by the latter would indeed have been very dangerous.  But Italy under Mario Monti has engineered a remarkable reform program, and so far, traditional political parties have cooperated thanks to the Premier’s diplomatic skills (to wit, his handling of the relations with Silvio Berlusconi). 

Spain, the next weakest link, has shown determination in cleaning up its banking system.  Finally, the ECB has hosed the European banks with hundreds of billions of euros, offering three year funding against a relaxed set of eligible collateral.

Confidence in Italy and Spain has increased, bank funding markedly improved.  Do we feel lucky today?  Do we want to face electors and tell them they are on the hook for €100 billion to Greece and counting?  If only we could be sure that Greece would make it.  Alas, that looks very difficult.

Greece would still be highly indebted, and whatever productivity gains it has made look unsustainable.

So far, Greece is experiencing a vicious circle with collapsing demand, investment, employment and tax receipts.  As a result, the fiscal deficit is still growing and the population is revolting.  As I wrote last January in this blog, the risks of political instability are rising in countries under economic stress.  So, further tightening looks counterproductive.

The more serious issues are structural, and therefore do not have short-term solutions.  According to a study published by Natixis, Greek hourly productivity in the manufacturing sector is good, but the value added produced by the manufacturing sector (as a % of GDP) is 40% that of Italy, 30% that of Germany and 26% that of Finland: the manufacturing sector is too small and doesn’t produce enough high value added goods. 

The service sector and particularly the bloated public sector are the real issues.  Yet Greece has done very little to improve this, in particular by going slow on privatizations.  To date, only a few billion euros of publicly-held assets have been sold; this compares with a €50 billion goal and a total base of €300 billion as estimated by former ECB board member Jurgen Stark.

So Greece looks unlikely to be able to grow any time soon.  This makes structural reforms very difficult: privatizations usually result in substantial job cuts, unless the output can be largely increased at a profit.  Think of oil, metals and the like that are sold in US dollars yet produced in devalued local currencies.  This looks unrealistic for Greece; it doesn’t produce these goods and it is in the eurozone.  As to tourism, where the country has both an existing infrastructure and great sites, competing with the likes of Turkey or even Dalmatia looks difficult.

As if it were not enough, ingrained habits, such as skirting the law, operating on a cash basis, avoiding taxes (be they on real estate, income or sales) will be even more difficult to reverse.  They may have had a rational and justifiable basis some time ago, but to the extent they have been absorbed by the culture, they will be that much harder to abandon.

All things considered, the most rational course of action for Greece is to exit the eurozone.  Then, it could follow either one of two models: Russia in 1999 which greatly benefitted from a devaluation of the ruble, political stability and positive economic policies, or Argentina in 2001 which veered to the left and proceeded to distort economic incentives to the point that inflation sky-rocketed, energy surpluses disappeared and the agro-industry declined.

It is also the most rational course for the rest of the eurozone.  Advancing another net €60 billion would achieve little except a short respite, would ratchet up tensions and in the end, destabilize both debtor and creditor countries.

Such a decision would probably cause volatility in the markets, but that could be countered by having the ECB stand behind the sovereign debt of the remaining eurozone members, and by having the latter to commit to better economic policies.

The second shoe to drop

It is remarkable that, so far, the global crisis which started in 2007, has had very few disruptive fallouts in the political domain.  There have been two casualties so far, Prime Ministers Berlusconi and Papandreou in Italy and Greece respectively.  In both cases, traditional parties have rallied behind governments led by technocrats and have approved austerity budgets.  In the US, where it all started, the situation is even more benign:  after causing a stir and some concerns, the Tea Party has overplayed its hand and failed to organize into a potent force, and President Obama, while inspiring faint enthusiasm, may be reelected come November.

Yet this may change.  Indeed, as governments in Europe, and soon in the US, cut spending (including social benefits) and raise taxes in order to reduce public debts and balance their budgets, populations may well revolt and seek alternatives.

In particular, the perception that such sacrifices are demanded by a foreign power, such as Germany, or by faceless financial markets which have been demonized by politicians and the media, combined with the absence of tangible forthcoming benefits may well cause populations to balk, to reject further austerity and loss of purchasing power, and to become receptive to the most demagogic promises of fringe politicians.

Granted this didn’t happen in the US during the Great Depression, but it did in Europe and I would argue that the explosion of media and social electronic networks make such a threat more serious today. Although in a different context, the Arab Spring is the clearest illustration of how a movement can gather irresistible strength.

In particular, what we are witnessing today is the squeezing of the middle-class throughout the West, and such a trend is unlikely to stop any time soon.

In April 1932, the liberal journalist Paul Scheffer of the Berliner Tageblatt wrote a powerful article on Hitler and how he seduced a despondent German middle-class.  This article was reproduced in the January/February issue of Current Affairs, and I am reproducing an extract here.

Hopefully, we will avoid a similar fate. But I do expect that, while the Great Recession mostly impacted financial markets and economies initially, it will have a much larger impact on politics and government in the next few years.

Le radeau de la Méduse

This painting by Gericault, one of the most famous of the French Romantic School, depicts survivors of the shipwreck of the frigate La Méduse as they are to be rescued by the brick Argus.  The disaster was caused by incompetent leadership and resulted in over 150 deaths.  The survivors picked from the raft resorted to cannibalism to survive.

It is too soon to compare the current travails of the eurozone with those of the sailors of La Méduse, but surely it isn’t to say that a euro shipwreck looks increasingly possible.

The latest report by the IMF on Greece is sobering.  The Greek economy is weaker than anticipated, the pace of structural reforms is slower (partly as a result of bureaucratic resistance, partly as a result of poor implementation); bank deposits keep on shrinking, credit to enterprises is falling, competitiveness is marginally improving, mostly as a result of dismissals.

While large institutional bank creditors had “voluntarily” agreed to a “haircut” of 50% on their Greek public bonds, rumor has it that the government wants to apply it only to the nominal value of the debt; by offering very low interest rates and extending maturities it would increase the effective “haircut” to 75%.

Greece is in a bind as the IMF, ECB and other euro governmental credits are exempted from the “haircuts” so that private creditors bear the brunt of the restructuring.  As I wrote in a previous note, there is little difference between a 75% haircut and reneging on one’s debts.  Argentina is a good example of that, and it has been a decade since it hasn’t been able to tap international bond markets.

Furthermore, can Greece fail to pay 75% of its public debts and still belong to the eurozone?  Can Greece restructure its public debts, exchanging them for new bonds worth 25% of the originals, and still characterize the process as voluntary? The answer is no and no.

Initially, I thought that the insistence by several European heads of state that the exchange be voluntary was nothing more than pride.  Now, I wonder.  What if big European banks had been sellers of CDS (credit default swaps)[1]?  Why not?  After all, the underlying credit risk was supposed to be zero; what a better business than selling for thousands of euros protection (CDS) against a risk that was non-existent (sovereign default)? 

European banks may have sold relatively few Greek CDS, but they may have sold tons of French, Italian and Spanish CDS, and a formal default in Greece would, at the very least, force these banks to provision against the other countries’ CDS because the myth of zero-risk eurozone would disappear.  Provisioning is a euphemism for taking a (big) loss.  I did look into the exposure of BNP and other banks to European sovereign debt but these banks only disclosure their exposure in their banking books, not in their trading books, which is very unfortunate under the circumstances.

The only way for Greece not to, in effect, renege on its obligations is for the IMF, the ECB and other euro governmental creditors to share in the losses of restructuring.  If not, Greece is out of the eurozone, with all the implications it carries for the rest of the area.  Even then, it is difficult to see how Greece will improve its competitiveness and enable its economy to grow fast enough, particularly given the European austerity and deleveraging policies.  At the end of the day, I can’t see how Greece stays in the eurozone.

The other eurozone members face different but equally daunting problems.  One is the fragility of their banking system.  In the US, banks account for 1/3 of total credit and capital markets for 2/3.  In Europe, the proportions are reversed yet banks have less capital and less stable funding (their ratio of loans/deposits being well over 1.0).  In recent weeks, big European banks have announced extensive divestiture programs to strengthen their balance sheets.  This may be good at the micro level, but it is bad at the macro, leading straight to recession.  And then there is the CDS question raised above.

European governments could have forced their hands with their equivalent of a TARP program (by far the most successful US effort to stem the 2007-2008 financial crisis).  Yet they shied away, afraid of jeopardizing their credit ratings.  This was a terrible mistake.  The financial situation will not improve until banks get stronger, and sovereign ratings will drop unless forceful governmental action is taken.

The other problem is existential.  Member countries share a goal but not the means to reach it.  They want to be a powerful economic bloc but they do not want to pay the price for it but harmonizing their fiscal and social policies, and in the process relinquishing some degree of sovereignty.  They desire a common currency but refuse to let the ECB back member states private banks not to mention member state public debts.  Finally, member state populations, when asked, reject the idea of a Brussels command, yet they now have to accept one from Berlin and, yes, Brussels.

As the situation worsens and tensions rise, the survivors are warily eyeing each other; numerous meetings have shown that they are unable to reach big decisions (such as recapitalizing their banks, getting the ECB to step up to the plate) or to display real solidarity.  The sniping has started (witness the French/UK[2] war of words on credit ratings) and will get worse. 

For all of the demonstrations of coordination and harmony, it is clear that Germany is the leader of the eurozone and France is the more equal of the rest.  When de Gaulle envisioned l’Europe des Nations, he meant not to relinquish sovereignty to Brussels; today, it has been relinquished in part to Berlin.  President Sarkozy will no doubt continue to play the game until the elections; doing otherwise would mean acknowledging a reality which the French dislike. 

Afterwards, changes are inevitable.  Pulling up to Germany’s level would require huge changes in labor laws and a shrinking of the public sector which seem beyond Mssrs. Sarkozy or Hollande powers.  France can’t revert to the age-old French/English/Prussian triangulation because the UK are outside the eurozone.  Italy, under strong leadership, could offer France some of the balance it wants.  Still, Italy would not offer a real triangulation, and as a result, I think that France will wish for less European integration rather than more, for a gaullian Europe of Nations so to speak.  Ironically, in so doing it would get closer to the UK position.

Perhaps a slowly healing US and resilient BRICs will give Europe six months to a year to avoid disaster.  But the pressure will not abate, the price to pay will not drop.  In the end, a Europe of Nations is more representative of the continent’s two millennia of history than a contrived eurozone.

Germany could mitigate the strength of its new currency by preserving a mini eurozone with Austria and the Netherlands.

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[1]  This is a question that hedge fund manager David Einhorn has also been asking.

[2]   I know, the UK is not part of the eurozone.

Market prices are what they are

Market prices are what they are, and it is an exercise in futility to argue with them; if you think they are too low, buy; if they seem too high, sell; or you can just stay away if they look too confusing.

As I am writing this note, consider this.  The French 10 year euro-bond yields 3.511% p.a. to maturity.  This bond is rated AAA.  The Brazilian 10 year dollar bond yields 3.486%, yet it is rated BBB.  Finally, the Colombian 10 year dollar bond yields 3.662% and is rated BBB-.

In other words, markets rank France just below Brazil whose credit rating is eight levels below, and only two levels above the investment grade floor.  Markets put France barely above Colombia which is rated nine levels below and barely investment grade.

Most musings by the press and economists point to France’s credit rating being lowered but remaining within the high investment grade zone (AAA to AA-).  But markets put France barely within the investment grade category; markets price in the possibility of a small loss or haircut. 

Actually, “small haircut” is an oxymoron: no country will be forced or willingly go into default simply to reduce its debts by 5% or 10%.  Rather, the small loss is actually an expected value: a given level of haircut or loss times a probability number.  So is it 30% x 2%? Or 20% x 10%?  Who knows. 

What markets are saying is that this probability number is no longer zero and that, barring strong European political will (which is so far conspicuously absent), it could be anything.

On the other hand, one could also question how strong the economies and financial systems of Brazil and Colombia would be if Europe were to spiral into chaos and the US would continue to twiddle its thumbs.  With all due respect to Brazil and Colombia, I have always thought that emerging market investment grade was another oxymoron.

So what will it be?  It is fair to say that France is no longer a AAA borrower, at least not until it makes some reforms that it has shied away from.  It is probably a AA- or an A+, three to four levels below AAA.  At the same time, I cannot rationalize buying Colombia or Brazil at current yield levels.  Would you buy buy Brazilian or Colombian bonds paying a nominal annual return of 3.5% to 3.7% if you had to hold them for 10 years, come what may?
.

Unless you are convince that a Japanese-like decade of deflation is coming, I find it very difficult to buy any sovereign bond at current yields. 

Proust’s financial madeleines

There are images that are forever associated with great crises, and every time we see them, we are reminded of their context, like Proust with his madeleine.  IMF chief Michel Camdessus watching over, as Indonesian President Suharto signed a financial assistance agreement, was the most vivid image of the 1997-1998 Asian Crisis; a generation of leaders across the emerging markets swore that never again would they be caught in such an embarrassing situation, which led to the massive foreign exchange reserves accumulation of the following decade.

The shared smirk between Chancellor Merkel and President Sarkozy, as they were asked about their faith in Prime Minister Berlusconi, has become the symbol of the current European crisis.  But what will it lead to?  PM Berlusconi has been replaced by PM Monti, and Italians are no fonder of public humiliations than Indonesians were back then.

Standard & Poor’s was criticized for having taken into account politics in its decision to downgrade the US.  They were just trying to look a few years ahead, and were right to introduce this qualitative factor.  If we want to look into the future of Europe, we should consider history and culture too.

Italy is the key to a successful European project.  It was a founding member of the European Coal and Steel Community in 1951, the first step toward the constitution of a European project, and of each of its subsequent iterations (the European Economic Community, the European Community and the European Union).  Its population and its economy have been of a size comparable to those of France and (West) Germany; leaving it out would have been like trying to build a stool with two legs.

The importance of Italy was and remains also rooted in history and culture.  Culturally, Italy is the gel that makes Europe click.  For all the outward demonstrations of affection, France and Germany are strong enough to head a balanced Europe, yet too different to make a harmonious one.  Imagine a symphonic orchestra with brass, percussion, woodwind but no string section.  It could play, but somehow it would not sound right and both players and the audience would soon tire of it. 

Finally, Italy is of strategic importance to a united Europe.  It represents its the Southern flank, bordering the Mediterranean basin, and offering the major entry point for people and goods from the former Yugoslavia, and beyond, through Turkey, from Central Asia.

So Italy, for all these reasons, is an essential part of Europe; should Italy fail, so would Europe.  And my judgment is that it won’t, and this for three reasons.

First, Italy’s current problem is one of economic and financial management, not one of solvency.  Unlike Greece, Italy can grow its economy to pay its debts.  Second, the rest of the euro zone has no choice but help Italy save itself, and themselves.  Third, Italy is on the edge of the precipice, and that is the only spot where people and countries will really accept to make changes; in this instance, this meant forcing out the prime minister, voting in a non-political cabinet led by the very able Mario Monti, and giving it two years to try and turn the country around.

Total success will be very difficult, but significant progress is likely.  In this case, France will find itself under tremendous pressure.  In the early 2000s, Chancellor G. Schröder substantially improved the German economic competitiveness through a broad mix of social, labor and tax reforms.    France did not, or could not, match this, and its labor productivity is generally estimated to have lagged Germany’s by at least 30% as a result.

If Mario Monti can convince his compatriots to make substantial reforms, France will be put in a very delicate position: not on the edge of the precipice to have to make big changes, but close enough to feel the intense pain.  Furthermore, with presidential elections coming up, it is out of the question to set up a “technocratic” government, and very unlikely to expect a coalition cabinet.  With profound political divisions and powerful trade unions accustomed to call strikes whenever they want to, the new president, Nicolas Sarkozy or François Hollande, may be in a position where the austerity measures that he can get approved in Congress are very unpopular yet insufficient to reverse mounting financial pressures.

Italy is not Greece, and I do expect that it will pull out, although I don’t expect this will be a linear process.  I do expect France to have a rough 2012 and possibly 2013.  Indeed, the image that will be most closely associated by this European crisis may not be the Franco-German “smirk”; it is yet to be seen and may be most Gallic in nature.

Confidence or else

In the final scene of Le Corniaud, a classic of French movie comedies, as they ride to the police station, a gangster (played by de Funès), is explaining to the naïf who helped in his capture (played by Bourvil) how to multiply his prize money.  The naïf is doubtful and de Funès can’t help but blurt out: “Don’t you trust me? But really, don’t you trust me?”

The US, Europe and China face their own economic problems, but the common obstacle towards their recovery is the lack of trust in which their citizens hold politicians.  And of course, the greater the needed sacrifices, the more people will insist that politicians be both competent and fair-minded.

Take the Greeks.  Here they were, spending their merry and voilà, they got into the EU, no questions asked.  And not only could they keep overspending, but now they could borrow all the money they wanted almost as cheaply as Germany. Was it their fault if they took free money, or was it the fault of the markets that threw the money their way?

The problem is that markets now want Greeks to become German-like overnight.  Other European countries would give Greece more time, if they trusted it.  And the Greeks themselves would likely bite the bullet, if they trusted that the pain would be shared among all parties, rich and poor, foreign creditors and fellow European nations.   

But whom to trust to lead them?  The Panhellenic Socialist Movement (PASOK) was in power when Greece joined the euro-zone; the New Democracy succeeded it and it was on its watch that serious deficiencies in public finance accounting were recorded; finally, PASOK came back in 2009 but its current leader, George Papandreou, has seen popular support evaporate.

With responsibilities for mistakes so evenly shared, it is understandable that no party is viewed as a savior and that the Greek population seems to prefer a coalition government.  Still, even if this is what happens, the task of the new government will be extremely difficult.  More austerity looks unlikely as not politically feasible.  Increasing the “haircut” on foreign creditors wouldn’t reduce public debt that much, and if it reached 75%, the whole exercise would look more like repudiation than restructuring.  A meaningful debt reduction would necessitate the ECB, the IMF and several governments accepting to take a loss on their loans, which is possible but, in some instances, would be a first.

Even if some combination of the above were achieved, Greece would still need to grow and become more competitive.  It is regrettable than privatizations, which could both help reduce the debt and form the basis of a more competitive economy, have been deemphasized lately.  This leaves only three possibilities: cutting salaries further, introducing permanent transfer payments within the EU or devaluing the currency. 

As I noted earlier, I think that further cuts in salaries are not in the cards.  Setting up permanent transfer payments is a possibility.  After all, exports account for 1/3 of Germany’s GDP, and of these, 63% go to the EU (35% or so go to the euro zone countries).  It is clear that countries like Germany (and the Netherlands) need a healthy Europe to which they can export in euro terms; their exports outside the euro zone benefit from being denominated in euro, rather than in a stronger deutsche mark.  For the richer members, it makes sense to permanently share some of these benefits with the poorer members of the euro zone.  But again, it is unlikely to occur in the near term.  Finally, there is devaluation, i.e. exiting the euro; this would offer immediate and sizeable financial benefits provided that such a move was accompanied by very tight management of public spending and inflationary expectations.

I think that the odds are 50/50 that Greece stays within the euro zone.  Staying, in my view, would necessitate the following: (1) the ECB, the IMF and European governments taking a “haircut” on their loans; if my memory is correct, some supranational institutions took a loss on their Argentine loans a decade ago; (2) the privatization program being expanded to up to $100 billion and implemented as soon as possible, with some features akin to the Chilean capitalismo popular in order to give the Greek population a share in its upside potential; (3) the coalition government implementing the adjustment program  more effectively than its predecessors, and (4) some sort of medium to long term transfer system at the euro zone level (there again, confidence will be key, confidence by the euro zone members that Greece will deliver on its promises, confidence by the Greeks that richer euro zone members will deliver on theirs).

Unless all sides can show results, confidence will collapse and we will be left with the exit scenario.  External financial assistance will be cut; this won’t be so difficult if European banks are recapitalized and Italy mends its ways.  The Greek population will refuse to sacrifice further, will reject traditional political parties and leaders; unrest and violence will grow; parties outside the mainstream will gain influence and by the end of 2012 the possibility of a military coup will have greatly risen.  Contrary to popular opinion, military coups usually occur because a sizeable portion (at least 1/3) of the population wants it, not because some general feels like grabbing power.  This would isolate Greece politically and economically and precipitate its exit from the euro zone.

Greece may still choose to exit the euro zone in a democratic fashion if it decides that it cannot bridge the productivity gap with the core of the euro zone, or if it decides that the costs of such an effort outstrip its benefits.

What is clear is that Europe must be rethought as it is becoming fragmented.  At present, we have the 10 non-euro countries, some of which have sizeable and vibrant economies (Poland, Sweden and the UK), we have a strong core euro zone (with the likes of Germany, France, the Netherlands, Finland), we have a weak euro periphery (Portugal, Greece, Cyprus) and finally some countries which could move into any of the above categories (Italy, Spain and Ireland).

If a euro zone with 27 members is not feasible, at least for a long time, what should Europe stand for?  If its purpose is to strengthen the economies of its members, wouldn’t a free trade zone achieve that, without the need for a common currency?  If the purpose is enhanced security, what is the need for a common fiscal policy?  What is the sense of a common central bank if this bank is not the lender of last resort?  Harmonizing fiscal and monetary policies is much more demanding than it sounds when one realizes that this necessitates harmonizing social, labor and defense policies too.   

For a thousand years, France, England and Germany’s predecessors have followed a policy of triangulation to advance their interests and keep rivals in check.  In a sense, the European Union was a way to keep tabs on each other, to get not so close as to surrender sovereignty yet close enough to discourage confrontation.  It might have worked if the Union had been limited to its founding members.  It wasn’t.  The status quo will not work.  Each nation, the wiser for the experience, must now decide what it wants and what price it is willing to pay. 

I think that the current financial crisis can be contained in a relatively short period of time if confidence can be restored.  It will take years to solve it and longer still for a new Europe to emerge.

Are European banks undercapitalized?

This is the subject of fierce discussions nowadays.  My view is that they are, and by a significant margin.

Capital is the ultimate cushion to absorb unexpected losses and to inspire confidence from market counterparties and customers.  In other words, carrying sufficient capital is an essential element of risk management and a cost of doing business.  Banks and their critics have argued that other elements need be considered as well, such as funding, customer profiles and reserve policies.

All of this is true.  European banks, by and large, rely more on wholesale funding than their US counterparts; this is evident when one compares ratios of loans to core deposits.  On the other hand, European banks point out that they do not net out derivative positions as American banks are allowed to do, and this is also true.

Perhaps the most telling indicator that European banks are undercapitalized is the fact that their risk weighted assets, against which they need to carry capital, represent a much lower proportion of total assets than they do at American banks.

To illustrate this point, we have selected four of the largest and best European and American banks.  Both European and American exponents include one bank with strong exposure to investment banking and one with a greater exposure to traditional commercial banking.  They are JP Morgan (JPM) and Wells Fargo (WFC) on one side of the Atlantic and BNP Paribas (BNP) and Deutsche Bank (DB) on the other.  For the European banks, we have also used their adjusted total asset numbers, meaning as reduced by netting out derivatives positions.

The results are eye opening:

	JPM at 9/30	WFC at 9/30	BNP at 6/30	DB at 6/30
Total adjusted assets	$2,289	$1,305	$2,175	$1,750
Risk weighted assets per Basel I	$1,221	$982	$863	$464
Ratio of TA/RWA	53%	75%	40%	27%

Let me reiterate that all four banks are presenting their financial results in accordance with the rules and regulations applicable to them.  I would also note that Wells Fargo is the closest to traditional banking, so that it makes sense that it has the highest TA/RWA ratio.  But recent history has shown that there is no such thing as a riskless financial asset.  Based on this observation, BNP and DB carry much less capital in relation to their total assets than JPM and WFC, and they are more exposed to a riskless asset, like a sovereign bond, suddenly becoming "risky" and therefore deserving of a capital cushion. 

From a common sense point of view, I submit that it is less risky to make relatively small loans to millions of customers who have checking and savings accounts with you than to hold billions in sovereign bonds or to extend billions in credit lines to banks whose actual risk profile is known, if at all, only to their management.

This is not to say that European banks should be demonized or punished.  It is close to impossible for major banks not to hold bonds from their own governments, and the dicier public finances get, the greater the pressure heaped on them to increase these holdings.  It is also understandable that, as the European Union developed and matured, they would want to expand their operations in neighboring countries.  Italy, now in the gun-sight of everybody, was a founding member of the European Community for Coal and Steel, back in 1951, and of every subsequent iteration up to the present day EU.

In that sense, these banks were not guilty of gross misbehavior, like making loans to borrowers who could not afford to pay current interest.  I can sympathize with European CEOs who clamor for their countries to get their act together and shore up their budgets and public borrowing needs.

But at the end of the day, counterparties and customers will determine the profitability and even the fate of European banks, or at least of their management and shareholders.  In this regards, European banks have been too cute, relying on rules that were too good to be true.  Perhaps because they enjoy much closer rapport with their governments than American ones do, they have forgotten that markets can quickly get unforgiving and ignore the best Power Point presentations.

With some exceptions, European banks need to raise fresh capital, now.