Once again, regulators have failed spectacularly. Gold hit £1,000 ($1600) an ounce yesterday for the first time, as equities fell, Club Med government bond yields jumped, spreads increased and the fear and loathing in the credit markets intensified - and all of that in response to the EU's banking stress tests on Friday night, which were supposed to reassure investors that all was well. What a farce. The tests' preposterous lack of credibility - they didn't even envisage the possibility that a government could go bust - have been greeted with the contempt they deserved.
The key problem is that if markets don't know what will happen to smaller, less well-managed financial institutions in the event of a sovereign default, then they will be less likely to lend to them or engage in other sorts of relationships. Perceived counterparty risk, as it is called, will intensify - and these less transparent firms will soon start running out of cash, potentially triggering a liquidity crisis. The amount of credit available to troubled economies will dry up, assuming that bigger, more obviously well-capitalised banks are unable to step in and fill the liquidity void
