In the bank meltdown of 2011, the financial sector was in obvious and blatant distress much to the obvious and blatant consternation of every central banker in the modern economic “community”. By September 2011, the US Federal Reserve re-opened (a second time) dollar swaps with the ECB to pass US $ funding on to local banks that were again in a eurodollar freeze. The Swiss National Bank finally pegged the franc to the euro after making threats for months in the vain effort to avoid having to actually do it.  At the same time finance ministers across Europe scrambled to maintain some appearance of order with various and reassuring-sounding acronyms (ESM, EFSF, etc).

These did not work, and by December, rumors of large and imminent bank failures (Credit Agricole, primary among those named) began to circulate so much that the Federal Reserve dropped its dollar swap penalty from OIS + 100 to OIS + 50. That same day, December 8, 2011, the ECB announced its plan to flood Europe with euros – the LTRO’s.

Ostensibly, these bank “saving” measures are supposed to right the economic ship on the continent. In the modern central bank calculation, banks are the economy and vice versa. Those liquidity measures did not, contrary to all expectations, leave a lasting imprint of calm; by Summer 2012 Spanish dysfunction replaced Italian dysfunction enough to threaten the euro itself. “Money” began to flow from the Southern regions of the euro currency zone toward the “core” or out of the euro altogether. Swiss, German and Danish government debt showed negative yields, and thus demonstrated the steep price investors were willing to pay to hedge against the end of the euro currency experiment.

While all this currency and banking risk was threatening the wider financial regime, the real economy in Europe was, as the story was told then, firming and the recovery was proceeding without much spillover. These central bank liquidity measures, we were told, were necessary means to avoid upsetting the delicate economic balance that appeared to finally be in Europe’s favor.

By the second half of 2012, just as the real central bank fireworks were unleashed, the calculus in Europe changed. The real economy was in obvious and blatant distress (though “unexpected”) but the financial and currency systems appeared to be firming and recovering. There was, and is, no obvious link between the two. The narrative of a firming Eurozone recovery was, at best, a ruse or illusion. While economists expected far better, the reality has been far worse.

As I wrote last week, the benefits of all this central bank activity really should be more conspicuous, particularly in the regions most affected by what is really a full-on depression.

What we have seen just in the past few weeks is a rapid deterioration in various economic metrics – it appears that just when it didn’t seem possible for it to get worse, it did.

Flash PMI estimate        Final PMI                      Previous Month Final PMI

Italy                    45.4                                  44.5 (7 month low)                 45.8
Spain                  46.2                                   44.2 (5 month low)                 46.8
France               43.9                                   44.0 (3 month high)               43.5
Germany          48.9                                    49.0 (2 month low)                50.3

“Germany and Ireland both fell back into contraction, while rates of decline gathered pace in all of the other nations covered by the survey with the exception of France, though the rate of contraction in the latter remained deep and was only exceeded by that of Greece. Manufacturing production contracted at the fastest pace in the year-to-date, as companies experienced a further solid decrease in inflows of new business. Output fell in all of the nations covered by the survey with the sole exception of the stagnation seen in Germany.

“March saw total new orders decline for the twenty-second successive month, dropping at the fastest pace since December. Demand was weaker in both domestic and export markets, reflecting lacklustre client confidence. The outlook for manufacturing also deteriorated, as the ratio of new orders-to-finished goods inventories dipped to a three-month low.”

It does not appear as though the mess in Cyprus has contributed to these worsening conditions, though that may change as we move forward. The past seven or so months had seen relatively calm in the financial and banking space despite the worsening and unending nature of depression in Europe, but that is where fears (rational) of Cyprus as a “template” may end up having the biggest impact.

Since March 15, the last trading day before the announcement of depositor confiscation, stock prices in various large banks across the developed world have been far more troubled than those of their non-financial cousins:

   3/15 Close      Latest         % Change

Unicredit (Italy)                       €3.83            €3.36              -12.2%
Banco Popolare (Italy)          €1.12             €0.92              -17.9%
Banco Popular (Spain)           €0.71            €0.57              -19.7%
Santander (Spain/UK)           €5.97            €5.23               -12.4%
Credit Agricole (France)       €7.18            €6.36               -11.4%
BNP Paribas (France)             €43.99          €40.09           -8.86%
Societe Generale (France)   €29.98          €25.72            -14.2%
HSBC (UK)                                   £720.10      £701.50        -2.58%
Barclays (UK)                            £320.55       £289.30        -9.74%
RBS (UK)                                     £307.90       £271.10         -12.0%

It’s not just European banks, either, as US banks have been diverging from new index highs domestically:

Bank of America                      $12.56           $11.74             -3.6%
Goldman Sachs                        $154.84         $142.44         -8.01%
Morgan Stanley                       $23.59           $21.08            -10.6%
Citigroup                                    $47.26           $42.53            -10.0%
Wells Fargo                               $38.20            $36.71             -3.9%

For rather obvious reasons, the PIIGS-based banks are performing far worse than their peers. What should be rather concerning across the financial space is the performance of the Italian banks since it is Italy that appears to most directly impact the “core” banks (particularly French banks that have an estimated €450-€500 billion exposure to Italy). Again, it was largely Italian distress that nearly brought the euro-dollar system to a catastrophic end in 2011. But it was Cyprus, and not the ongoing depression, that appears as the catalyst for bank stocks, particularly Italy. That is extremely telling about what is motivating investors and risk perceptions – perhaps investors are finally beginning to understand that ongoing bank insolvency and the depression are actually an inseparable mess.

If these stock prices, not to mention the return of negative yields in both Switzerland and Germany, are evidence of increasing risk perceptions then it would put the ECB once again behind the curve. Last September’s promise of an open-ended, “do whatever it takes” SMP program of purchasing peripheral sovereign debt would be mis-targeted in relation to current fears. If the deposit scheme in Cyprus has unsettled bank investors across the aggregate capital structure (yields and spreads on Italian bank debt have risen, as well), the SMP would do very little to allay those fears since they are not directly related.

What Cyprus finally exposed is that there is not enough “capital” in the capital structure of the European banking system to clear bad debts and finally remove solvency concerns. Sovereign bond prices, the variable the ECB is using as a financial crutch, is only a minor piece of the risk/solvency puzzle. The current ECB/political plan involves building “capital” through other means – low cost of funds subsidizing bank profits and some combination of extend and pretend, including allowing banks to re-calculate their risk weighted assets with the help of black box matrices and likely over-optimistic assumptions.

It was more than three years ago that a tiny country in an almost-forgotten region of Southern Europe brought this massive financial imbalance to the world’s attention. Where Greece started the Sisyphean ball up the bailout/acronym hill in 2010, there are no shortage of candidates, large and small, to knock the banking system back down again. That, in itself, is revealing.

Even Slovenia is beginning to sound like a combination of Greek economic dysfunction and obvious Spanish denial:

“The Slovenian state is liquid and can meet its obligations without any problems for now, but the situation can change significantly on June 6 unless we issue new bonds by then.”

Those words from the now-former Slovenia prime minister encapsulate so much of the past three years in Europe – everything is fine, but it’s not without some new bonds or something. No wonder risk aversion appears to be on the rise yet again.