A tell-tale sign that the worst is still to come

There is euphoria in the financial markets caused by yesterday's decision of five central banks to provide 'unlimited' amount of dollars to European commercial banks. The European Central Bank, the U.S. Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank agreed to offer dollar loans to beleaguered banks.

The problem with the dollar funding in European banks arose because their American counterparts stopped lending to them. With so much bad debt on its books, the European banking system is set for a major upheaval. At the time of the introduction of the euro, it was a relatively safe and profitable bet that credit spreads of different countries of the eurozone would converge. European commercial banks, glut with liquidity and all too eager to earn a few extra bips, loaded up on debt of weaker countries. A possibility of a default of a eurozone country was just unthinkable at that time. Today, however, such a possibility does not seem all that crazy. In fact, in my opinion, only through default and expulsion of non-euro-treaty-compliant countries, the situation could be remedied. Small fixes will only prolong the agony.

In normal operations, US dollar funding is important for European banks but not that crucial. Most of their lending is done in ueros. Dollars are needed primarily to finance commodity producers, as commodities are still priced and traded in the American currency. Not having dollar funding would mean only reduction of the banks' loan portfolio and greater cost of financing for commodity producers - not much to worry about.