We have discussed, at length, the symbiotic (or perhaps parasitic) relationship between the banking system in Europe and the governments (read Central Banks). The LTRO has done nothing but bring them into a closer and more mutually-reinforcing chaotic relationship as we suspect many of the Italian and Spanish banks have gone all-in on the ultimate event risk trade in their government's debt. It should come as no surprise to anyone that the bulk of the Greek bailout money will flow directly to the European banking system and Credit Suisse has recently updated the bank exposure (by country) to peripheral sovereign debt that shows just how massively dependent each peripheral nation's banking system is on its own government for capital and more importantly, how the core (France and Germany) remains massively exposed (in terms of Tier 1 Capital) to the PIIGS. Retroactive (negative) salary cuts may well not be the worst of what is to come as the bankers deleveraging returns to bite them in a phoenix-like resurrection of sovereign risk on now even-more sovereign-bloated (and levered) balance sheets.
At what point does a regulator realize that perhaps it is not such a great idea to have double the exposure to the local sovereign (Greece/Italy) relative to Core Tier 1 Capital? Or is contagion risk due for review in Basel IIIIIIIII?