European Bank Failures Expand as European Disinflation Worsens

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The European Central Bank is rumored to fail 25 banks in the Eurozone based on a lack of capital and liquidity, according to a leaked draft communique. At the same time, disinflation and weak demand has caused economic growth in the UK to fall 22% sequentially in the third quarter of 2014.

The ECB is currently reviewing lenders throughout the Eurozone in an attempt to identify which banks are likely to fail as a weakening euro, a recession in Italy, and worsening economic conditions in France and Germany threaten European stability. Of the total banks reviewed, 19% are likely to fail throughout the Eurozone.

While bank failures could cause a bank run that would worsen an already lack of liquidity throughout the Eurozone, ECB President Mario Draghi has publicly stated that banks will need to fail to prove that losses are behind them. The ECB has not publicly confirmed exactly how many banks will pass its stress test.

Earlier in the year, Portuguese bank Espirito Santo Financial Group declared bankruptcy, less than two months after receiving a 4.9 billion euro bailout from the Bank of Portugal. The ECB’s report may indicate that more bank failures in the core of the Eurozone are set to fail in 2015.

Disinflation, Hindered Growth

A decline in inflation has caused bond yields to tumble throughout the Eurozone, with the UK seen as a stronger economy thanks to its independent currency. However, the UK saw its GDP growth slow in the third quarter, according to a new report by Britain’s Office for National Statistics.

According to the report, GDP growth has slowed to 0.7% from 0.9% in the second quarter. Construction led the growth at 0.8% with services growing at 0.7% on a year-over-year basis. The slowdown has caused some economic analysts to revise their growth projections for 2015 downward, citing disinflation in the Eurozone as a headwind for aggregate demand in the European Union, which remains Britain’s largest trading partner.

Some analysts have warned that economic growth in the UK peaked earlier in 2014 and is likely to continue to slow down on weakening agricultural and manufacturing performance. Labor Shadow Chancellor Ed Balls said that the British government would continue to work on building new homes, raising the minimum wage, cutting business taxes, and expanding social services.

ECB Struggles to Add Liquidity

To fight deflationary pressures and strengthen banks’ liquidity, the ECB began a bond-buying program similar to the Federal Reserve’s Quantitative Easing, which itself is set to end before November. The ECB’s asset purchasing program focuses on government-issued paper, but is expanding into high-rated corporate bonds.

However, some analysts are warning that the ECB is having difficulties finding enough bonds on open markets to fulfill its targets due to high restrictions on which assets are eligible within the program’s guidelines. Those few assets that qualify are held by fund managers who are unwilling to offload them unless there is a significant premium, while bond issuance has remained constrained throughout 2014, which has further restrained liquidity and caused prices to rise while yields fall.

In a recent note to clients, BlackRock said that the corporate bond market is “broken” and warned that lower bond trading volumes was helping to keep yields depressed throughout the market.