A European Banking Union

Wolfgang Münchau, writer for the Financial Times, has written a very clear article about the possibility of a European banking union.  What is most interesting in the piece is his reflection on what a banking union might mean for he eurozone.

The basic point is that given the banking problems that now exist in each country of the eurozone and in the whole of Europe, almost everyone is moving to the conclusion that a banking union of some form is needed.  Even German chancellor Angela Merkel has seemed to move in this direction in recent days.  Some, like ECB President Mario Draghi, are getting rather aggressive about such a move.

The need is certainly there, highlighted by yesterday’s announcement that Portugal  will inject €6.6 into three of the country’s largest banks. The Portuguese government claimed that the need came about due to the very severe new capital requirements of the European Banking Authority.  

Let’s concentrate on a few of the points that Münchau makes in his article.  First, almost all banks within the eurozone should be a member of the banking union…and, this includes Spain’s Bankia and the Landesbanken of Germany.  That is, the bar for membership, Münchau argues, should be very low.  The banks themselves would become members of the banking union and not of the individual states making up the banking union.

After this, the banking union needs a treasure chest… Münchau suggests a total of €1 trillion…to help banks recapitalize.  The suggestion here is that part of the funds would initially come from member governments but eventually the full €1 trillion would be raised by a eurozone bond or something similar.  This fund would make the banks solvent, although a large number of the banks would, in essence, be nationalized.

A second fund would need to provide deposit insurance.  The essence of this idea would be to stem bank runs or the possibility of bank runs.  The deposit insurance would be based upon bank membership in the banking union and not upon whether or not the country remains within the eurozone. 

The basic model of the deposit insurance fund is that of the United States and the Federal Deposit Insurance Corporation, the FDIC.  This would mean that where ever the deposit insurance fund is located it must have the power and backing to be able to close banks down, much in the way that the FDIC does.

This means, however, that the deposit insurance fund would have a supervisory function, one that would have the ability to examine banks on a regular basis and one that would have the ability to limit bank functions and operations as is needed.  No more “mickey mouse” stress tests, but real examinations that had a sting to them and that would be enforced.

Where to locate this regulatory authority of examination and closure is a problem.  It would not have to be “independent” as is the FDIC in the United States but could be connected in some way to the ECB.    

But, Münchau continues, this starts to widen the circle.  The author states very clearly that to give the deposit insurance fund the power and the authority to close a bank, regardless of what country the bank claims as its home, means that the political union of the member states must be sufficiently strong to back up the banking agency in its efforts.  National interests cannot interfere with the deposit insurance fund because this would immediately destroy the credibility of the banking union. 

“Without a commitment to further political union, deposit insurance is either ineffective or ruinous.”

People in the eurozone have begun to talk about the possibility of bank runs and systemic bank failures.  Here I refer you to a recent article in the Economist magazine, “The Fear Factor: Preventing a Big European Bank Run”.

There has been a change in attitude with respect to European banking problems...focus has shifted from the bank problems being one of illiquidity to being one of solvency.  “Unlike six months ago, officials now realize there is no alternative to a banking union.” (This from Münchau.)

Notice, that the solvency question has arisen due to the concern for the banking system…not in terms of sovereign debt.  So, the thought process has still not moved as far as it needs to go!

However, a “proper” banking union is going to require a political union.  And, the political union is going to require a fiscal union. 

If Europe moves on down the road in creating a European banking union, then, this argument goes, Europe will move on down the road in creating a central European fiscal and governing union. 

The question is, therefore, will European officials move on the creation of the European banking union?

To do this, some Europeans are going to have to step up and become leaders.  Up to this point, the lack of leadership has been the most deficient resource on the European continent. Will someone please step up!  

Europe's Problems Have Really Been Connected With Insolvency, Not Liquidity

The working definition of a liquidity crisis that has prevailed during most of my professional career has emphasized the short-term nature of such a crisis.  The financial crisis in Europe does not match this definition! 

Historically, a liquidity crisis occurs when there is a change in expectations in the financial markets that causes the buy-side of the market to re-evaluate values.  The re-evaluation is always on the down-side and buyers do not re-enter a market until they re-gain some confidence as to where prices should be set.

Until that confidence is re-gained, market prices can be in free-fall.

A classic case is that of the financial crisis that occurred in 1970 that was related to the commercial paper market.  The shock that hit the market: the credit rating of the Penn Central’s commercial paper was downgraded.  The downgrade surprised the market because the financial condition of the Penn Central had been assumed to be solid until the downgrade was announced. 

Market participants responded by questioning the ratings on other issuers of commercial paper.  If a company, like Penn Central, that was carrying a high credit rating could be downgraded what other companies might face the same fate. 

As a consequence of this downgrade, companies issuing commercial paper could not roll-over their debt and therefore had to go into their commercial banks and draw on their “backup” lines of credit to cover maturing debt.

The commercial banks were then faced with selling their “liquid” assets in order to fund the lines of credit.

The money markets faced a downward spiral of prices as participants wondered about where prices should be set in the commercial paper market and in the market for short-term Treasuries.

This, to me, is a classical example of what a liquidity crisis is all about.

How does one combat a liquidity crisis?  This is where the central bank comes in.  A central bank combats a liquidity crisis by providing sufficient liquidity to the financial markets so that selling assets, like Treasury securities, ceases and order is restored to the pricing process.

Historically, the vehicle used to accomplish this outcome has been the discount window of the Federal Reserve.  In the case of the Penn Central crisis, the Federal Reserve threw open the discount window and stated that any bank needing liquidity to cover draw-downs on their backup lines of credit could come to the discount window and borrow what they needed. 

The caveat on this opening of the discount window was that the borrowings were only to last for a short time until the crisis past.  It was generally expected that the situation would resolve itself within about four weeks. 

A liquidity crisis is a short-term phenomena!  A liquidity crisis occurs because market participants, on the buy-side, do not have sufficient information to set prices…hence, the demand-side of the market is extremely weak.

I have constantly argued over the time that I have been writing this blog (started February 2009) that government officials were wrong to consider the sovereign debt crisis in Europe and the ensuing banking crisis as a “liquidity problem” and not a “solvency problem.” 

The problem has been that the market may not know exactly where the prices of financial assets should be, but they do know that these prices are below the value at which governments and banks carry the assets.  The owners of the assets will not sell them because it would bankrupt the institution.  But, this is not a “liquidity problem” in the classical sense.  The problem is connected with the solvency of the institutions.

The officials in Europe (I will not call them leaders) have attempted to treat their problems as a liquidity problem.  Their responses to the financial markets has constantly been to provide troubled governments and financial institutions sufficient liquidity to work their problems out thereby “kicking the solution to their problems down the road.”

Now, even the “liquidity solutions” are coming back to further weaken these institutions.  Note the description in the New York Times about the liquidity provided to European banks by the ECB.

“At the root of Spain’s crisis has been a drastic flight of foreign capital from the country — one that, paradoxically, has been accentuated by the European Central Bank’s program of providing low-cost three-year loans to European banks so that they might buy their governments’ bonds.

When the central bank created that program late last year, and dispensed two rounds of loans within a few months, it was credited with having done much to ease Europe’s crisis. 

In the case of Spain, while the program bought time, it has made the country’s underlying problems worse. Spanish banks have by far been the most aggressive participants in the cheap-loan program, having borrowed more than 300 billion euros from the central bank. And much of that money was spent on Spanish government bonds. 

In the short term, those bond purchases helped the government by bringing down interest rates — by reducing Madrid’s cost of borrowing. But as a result, Spanish banks now own a larger share, about 67 percent, of their own government’s debt than the banks of any other country in the euro zone, according to research by BNP Paribas. 

Now the value of those bonds is declining — prices fall as yields rise — and further weakening Spanish banks.”

In my experience in working with failing institutions, those running the failing institutions continue to deny the reality of their problems by ignoring the reality of their insolvency and by pointing their fingers at any other possible cause of the failure in order to hang onto their illusions. 

 

We hear, “the problem is caused by greedy speculators”; “the problem is just a problem of liquidity”; “the problem is the Germans”; and so on and so forth!

Just having returned from two weeks in Rome, I can’t get the image of Nero playing the fiddle while Rome burned out of my mind.  The fiddle-playing of the European officials has allowed them to suppress the real issues that have to do with the solvency of their governments and their banking institutions and the reform and restructuring that needs to be gained in their cultures.  As long as this denial continues the issues will not be resolved.    

Europe Hasn't Got It Yet!

The yield on the 10-year bond issued by Portugal jumped by 70 basis points yesterday coming close to a 14 percent yield.

Today, Greek 10-year bonds jumped dramatically to yield more than 38 percent.

Spain’s prime minister begged other officials in the eurozone to ease up on the deficit targets his country is supposed to hit. 

The European Union is being urged to cut the cost of Ireland’s bailout.

800 European banks obtained €530 billion in three-year loans this week from the European Central Bank…up from 523 banks and €489 billion in three-year loans in December 2011.

The head of Germany’s Bundesbank has attacked the president of the European Central Bank, Mario Draghi, over the behavior of the ECB.

France is facing a change in government in the up coming elections.

The European recession continues.

And, protests increase throughout the eurozone.

A system is dysfunctional when the solutions it tries over and over again fail to resolve the problems that are plaguing the system.

One keeps hoping that the pain that the system is feeling will finally become great enough so that the system will try to find a new solution…even if that new system presents a new set of difficulties.

Officials in Europe have continually looked at their situation and provided the diagnosis that their problem is one of liquidity.  Hence, these officials provided more liquidity to their system, first through debt repayment postponements, then through bailouts, then through debt-restructurings, and now through three-year loans to banks to buy time for sovereign nations to get their act in order.

But, the nations that are helped never really deliver. 

No one seems to trust Greece. (http://seekingalpha.com/article/374631-liar-liar-pants-on-fire-the-greek-case) 

Investor’s increasingly believe that Portugal will need a second bail-out.

Ireland is now going to hold a referendum on the fiscal compact of the eurozone.

And, Spain is coming nowhere close to meeting its targets on debt reduction and hence is demanding relief from the targets.

Nothing seems to be holding together. 

So, could it be that maybe…maybe…the problem is one of insolvency and not liquidity?

But, no one likes the I-word.

Liquidity problems can be blamed on that shady crowd of international financial interests and speculators. 

Thus, it is assumed that if sufficient liquidity is provided the markets then this will defeat these “greedy bastards” and everyone can get back to business as usual. 

However if the problem is one of insolvency, this means that the blame must be placed on the governments themselves and the politicians that run these governments. 

But, have you ever seen a politician take the blame for anything?

No standing government will ever take the responsibility for creating a fiscal crisis.  But, that is what we have and until some of these governments are forced to accept the fact that the problems that they are now facing exist because they are insolvent we will get no resolution of the problems.

My best guess is that this stalemate will continue because there are no leaders that will step up and declare that “the Emperor is wearing no clothes.”

European officials will continue to fight the fantasy of illiquidity.  And, they will continue to fight this fantasy even as the recession they are facing worsens.  That is what a dysfunctional system does.

To continue this fantasy, we learn that the International Swaps and Derivatives Association has declared that in the Greek situation there has not been a “credit event” and thus the credit default swaps associated with the Greed debt cannot be exercised.  Where is Walt Disney when you need him?