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Event Risk Remains Huge Despite Central Banks' Intervention

Friday, 16 Sep 2011 | 4:20 AM ET

There was talk of an event risk going into Thursday’s market open, and the speculation proved correct.

CNBC.com

After UBS announced it had lost $2 billion due to an alleged rogue trader, the world's major central banks stepped into the void created by the euro zone debt crisis.

The Federal Reserve and the European Central Bank, in co-ordination with the Bank of England, Swiss National Bank and Bank of Japan announced a plan to offer three-month dollar loans to commercial banksin order to avoid a liquidity crisis in the euro zone banking system.

The intervention, 24 hours before euro zone finance ministers met in Polandto discuss their next response to the Greek problem, boosted the euro and saw stocks in the euro zone’s troubled banks rise sharply, with the exception of UBS .

The intervention brought much-needed relief to the market, according to John Higgins, a senior market economist at Capital Economics, but is no “silver bullet.”

“Of course, the demand for dollar funding in the euro zone is symptomatic of a broader liquidity squeeze,” Higgins wrote in a research note.

The problem for Higgins is that while liquidity is not as big a problem as it was in late 2008 following the collapse of Lehman Brothers, solvency is.

“Even if banks in the euro-zone have less of a liquidity problem on their hands today than they did in late 2008, they have a greater solvency problem. This is reflected in the fact that the cost of insuring against a default by the banks is much higher,” Higgins explained.

“Policymakers’ response to the financial crisis was to recapitalize the banks and transfer risk to the public sector,” he said.

Escalation of Crisis?

This is now coming back to haunt the banks, according to Higgins, as they hold so much government debt and the governments themselves are in no position to offer renewed support.

“We expect a further near- to medium-term escalation of the euro zone crisis involving the default of a sovereign in, and the possible departure from monetary union of, at least one country,” said Higgins.

The move by the central banks has been welcomed by Carl Weinberg, the chief economist at High Frequency Economics but he thinks more action is needed.

“While liquidity provision by the ECB is an important short-term solution to the logjam, the ultimate longer-term restoration of confidence in the market can only come when solvency is assured for all financial institutions,” said Weinberg.

Weinberg believes the only game in town is saving the banks. “As we see it, the time frame required to rehabilitate Greece’s public finances now exceeds the patience of its creditors and donors.”

The start of trade on Monday is now a huge risk, according to Weinberg, if Friday's meeting in Poland fails to end with concrete action.

“The most important thing right now, in our view, is to save the banks regardless of what happens to Greece. If we lose the euro land banking system because governments did not bother to think ahead about what a Greek default might mean, then we will get a depression in euro land,” said Weinberg.

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