European Fiscal Union and European Banking Union

An apparent first step was taken last week to create a banking union for the eurozone.  Although a lot of details were left out of the agreement and a lot of questions were not answered about such a union, hopes were raised that such an initiative would lead to more details and more answers.

One of the big hopes that attached itself to the possible creation of a European banking union is that it would help to produce a working-relationship amongst the 17 European nations included in the effort to then move on toward the creation of a European fiscal union. 

“Making it work is critical.  In the short term, a signal of tighter regulation in the future—along with bailouts for troubled banks—is needed to stem the flight of capital from countries with banking problems, which threatened to spread to financial institutions throughout Europe,” writes James Kanter in the New York Times.

“In the longer term, by agreeing to cede power over banks, European countries hope Germany will trust them more and eventually stand ready to share eurozone debt, which could help them ease austerity measures and adopt pro-growth plans to revive their struggling economies.”

To “share eurozone debt” will require that the eurozone countries agree to some kind of fiscal union.  

Nothing, however, was accomplished last week concerning this “sharing” of eurozone debt.

“Countries led by Germany agreed to allow a new, permanent European bailout fund to recapitalize banks directly…In exchange, Germany and its allies won more rigorous centralized authority over lenders.”

In essence, Germany gave up nothing and yet accumulated greater relative authority in Europe over bankers should such a central banking union actually be formed. 

The early interpretations of last week’s summit agreement were that Italian prime minister Mario Monti trumped German chancellor Angela Merkel.

Further readings are tending to go the other way.

Not only did Germany achieve more say in any European banking union that is formed, it also gave away nothing in terms of promising more money for any kind of European fiscal union that is formed. 

Wolfgang Münchau writes in the Financial Times that the most important event that took place last week was the statement by Ms. Merkel that there would be no eurozone bonds “for as long as I live.”

To Münchau, this statement reveals, that Ms. Merkel “is not serious about political union.”

And, this leads back to a point I made in a previous post.  

“Germany, the creditor nation, “is acting as creditors always do. It wants to be paid back or put debtors through default proceeding to extract maximum benefits.”

Germany, it is argued, can ultimately achieve its goals by one of three paths: deflation, inflation, and writing checks.

“Deflation in the periphery would eventually make it competitive, and is Germany’s favored option. But, as we are seeing, it naturally leads to default by weaker banks and governments.”

With inflation, Germany loses because it gets paid back in cheaper euros. By writing checks, Germany would pay off the periphery for leading an undisciplined life: Another case of moral hazard.

To others, Germany has made a decision. They have opted for the first of the three: European deflation. The idea here is that the deflation would become so painful to the periphery nations that they would finally move to correct their situation.

Europe is in the midst of a big experiment in Game Theory.  But, one has to decide what form of game theory is being played.

Some analysts argue that the game being played is that of “Chicken.”  In the game of chicken, the goal is to make someone else get out of the game first.  The game is only played once and there is potentially only one winner.

Another game is called “The Prisoner’s Dilemma.”  If the Prisoner’s Dilemma is played only once, everyone comes out with a bad result.  However, if the Prisoner’s Dilemma is perceived as a long-term game that is played over and over again, the players in the game can “cooperate” and all can reach a better solution over time.

If the European situation has evolved into a “Game”, the question then becomes, “What game is Germany playing?  Chicken or The Prisoner’s Dilemma?” 

If it is “Chicken”, then the eurozone certainly will fail.

If it is “The Prisoner’s Dilemma” then there is hope that a “cooperative” solution will be achieved. 

But, that means that for a banking union and a fiscal union to be formed…nations must give up some of their sovereignty really cooperate in the solution.

However, this last solution is a very difficult one for proud, sovereign nations with histories of “non-cooperative” solutions going back centuries, to do.

In this sense, using the formation of the United States as a proxy example for the European nations to form a federal fiscal union does not exactly fit.

Still, a first step has been taken.  I hope that further steps follow.  I believe that we all will benefit from Europe having a single currency, a banking union where all European banks have a single regulatory authority and deposit insurance is available to all institutions, and a fiscal union where the countries of the eurozone cooperate on budgetary matters.

Such an result is, obviously, not a foregone conclusion!     

First Steps Toward A European Banking Union

Did Europe really take its first steps toward a banking union?

It appears that they did in an all-night session of eurozone officials at the EU summit.  An agreement was reached concerning the creation of a single bank supervisor, under the charter of the European Central Bank.

The “change in banking supervision could be the most far-reaching of all the decisions taken. Instead of the hotchpotch of 17 different bank supervisors, there will now only be one for all eurozone banks, a major step towards a so-called banking union banking union that is arguably the most significant change to the single currency area since it was created.”

This would be significant step!

It would be significant because you now have 17 different sovereignties, 17 different banking regimes, and 17 different regulatory bodies.

Going to a single banking union would be very similar to going to a single currency…and, with all the problems of managing a single currency. 

Given the current system, many of the sovereign governments in the EU have used their banking to support their undisciplined fiscal policies.  Up until recently, all sovereign debt was considered to be riskless, so the banks were able to buy up lots and lots of this sovereign debt and use it in a way that allowed them to meet regulatory capital requirements.

As a consequence, these unconstrained national governments could rely on the banks to buy their debt and the banks could rely on national regulatory bodies to uphold their capital positions because they held this “riskless” national debt.  And on, and on it went in a “vicious circle” between the banks and the sovereigns. 

And, the affected national governments “talked up” their banks as the banks drifted more and more into trouble with some becoming insolvent.

In order to get through the current banking crisis, eurozone officials agreed to “radically restructure” the €100 billion recapitalization plan requested by Spain.  Under the new agreement the funds would go directly into Spanish financial institutions removing the responsibility for administering the bailout from the Spanish government itself. 

Also, in the agreement, Italy will get some concessions in how it is treated in the upcoming plans and further review will be given to Ireland, consistent with these efforts.

Bottom line, the eurozone nations will no longer have the responsibility for bailing out their own banks.  The fund that will be used to provide the pool of funds for these bailouts will be the European Stability Mechanism (ESM).  Currently, this fund has €500 billion in resources. 

Timing becomes all-important in the creation of this central banking supervisory authority, because the situation, as it stands, is unsettled.

The ECB is to have plans for this banking authority “before the end of the year” because the creation of this banking supervision is “a matter of urgency.”

Spain’s bank bailout will take place immediately under the new guidelines and then could be switched to the new supervisory authority when it is in place. 

The problem faced by those attempting to create the new eurozone banking union is that times have changed and the world is constantly moving into an electronic future.  The eurozone cannot just set up a regulatory system to just deal with current problems!

This is a problem that has been highlighted in the United States by the recent JPMorgan Chase losses.  Financial institutions have moved into a new world order, driven by the attributes of information technology.  Financial institutions are scaling up to operate within this virtual world.  The smaller banks will not be able to compete in this technology space and hence the average size of a financial institution is going to increase.

According to FDIC statistics, there are 525 banks in the United States that have assets in excess of $1.0 billion.  The average size of these 525 banks is over $22.0 billion.  According to Federal Reserve statistics, the 25 largest domestically chartered banks in the United States average $290.0 billion in total assets.  Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo have $8.0 trillion in total assets divided among them…an average of $2.0 trillion each.    

The largest 25 domestically chartered banks plus the offices of foreign-related banks, control more than 70 percent of all commercial banking assets in the United States.  It is these organizations that will be driving the introduction of the new technology.  Folks, this is what the future is going to look like…and the regulators, in my mind, cannot stop it from happening!

And, technology is driving this scaling up.  I call your attention to an edition of a journal published by the Institute of Electrical and Electronics Engineers called IEEE Spectrum.  The cover story of the June issue June issue is “The Beginning of the End of Cash”.  Let me tell you, if the electrical and electronic engineers devote a full issue of their journal to this subject…you better watch out!  How about this article...”Quantum Cash and the End of Counterfeiting.”

This is why, to me, that an article like the one written by Philip Augar in the Financial Times is scary.  The title of the essay is “Too big to manage and regulates is what matters now.”  His suggestions are: one, to break up the banks along Glass-Steagall lines; two, for banking supervisors “to leave as little as possible to management discretion and to go for bold, simple rules that are easy to understand and possible to enforce; and three, to remove the grotesque incentives that encourage corrupt behavior.

What universe does Augar inhabit?

The problem is that many suggestions about the banking system are along these lines today.

Yesterday, the officials of the eurozone took a bold, initial step in creating a new banking structure for Europe.  We all hope that they will continue along this road…and will continue at a fairly rapid pace.

However, it will not do anybody any good if those creating the new banking structure look solely at the past.  Finance is just information and the use of information is going to adapt to the technology available to it. 

Banks…financial institutions…are getting better and better at using the new information technology. 

Bank managements…and the managements of financial institutions…have not caught up with these new advances in information technology.  There ability to judge and control risk is just one place where these managements fall short of where they need to be.

Yet, I would suggest that these bank managements are light years ahead of where the regulators are in terms of understanding and managing the use of information in this modern era.  Creating a banking union and a regulatory structure that does not accommodate this fact is either going to fail, or, and this I believe, is going to drive all the technologically savvy organizations out of their sphere.  That is, the banks will find a way to leave the industry.

There is no question in my mind that these banks will do it…and leave the new banking union with just the “dogs.” This possibility will become more of a reality if the European banking union is formed.  But, I believe, the European banking union must be formed.

By-the-way…if you have not been reading my blog over time…I believe that the United States is leading this charge.

Who needs a commercial bank?  I don’t!    

More Banks Downgraded

Today’s news: 28 Spanish Banks were downgraded by Moody’s Investors Service.  Included in this list were Banco Santander SA (SAN) and Banco Bilbao Vizcaya Argentaria SA (BBVA).

Moody’s’ cut the ratings of 16 Spanish banks on May 17. 

Again, the argument can be made that this move was "too little, too late."

Yet, perhaps the most important thing to realize is that especially if the move by Moody’s is “too little, too late,” the situation in the banking system has not improved even though a substantial amount of time has passed since the banks entered into this “dark” region.

That is, maybe the banks should have been downgraded six months ago…or, nine months ago…or twelve months ago.  What we should reflect upon is that the banks have not improved their financial condition over this six months…or, nine months…or, twelve months…so that the ratings would not have had to be dropped!

The banks did not respond to the conditions because everyone in Europe seemed to believe that the problems faced by the banks were “liquidity” problems and not “solvency” problems, and that eurozone governments also did not face “solvency” problems.

The conditions cited by Moody’s for the downgrade included the weakness of Spain’s sovereign debt and the increasingly larger losses being recognized by the banks on commercial real estate loans.

Today, Spain requested funds for a banking bailout from members of the eurozone.  The lingering question still remains about when Spain, itself, is going to ask for a formal bailout.  Spain’s bonds are now trading near peak level spreads over German bonds of the same maturity.  The concern here is that these high yields cannot lead to a sustainable financing of the national government.

The situation of Italy is not unlike that of Spain, so there is concern over when the financial markets are going to turn more strongly on the government of Italy.

But, no one seems to have the will to act.  Still no leaders have arisen.  The general belief that the solution must ultimately rest with Germany receives cries of strong protest from German officials.  Short-term plugging of the dike is about all anyone can do. 

It is becoming more and more obvious that the only way the European situation will be corrected will be when the European governments “bite-the-bullet” and actually accept the fact that there is a massive need for structural reforms in most countries.  However, these government officials, in the past, postponed actions over and over again arguing that the problems were just ones of “liquidity.”  Now they have moved to claiming short-run cash injections will solve the “solvency” problems. 

The possibility that European government officials will really consider structural reforms for their societies still seems a distant fantasy. 

There has been talk of a banking union with the eurozone.  Yet, no one really seems serious about giving up their national interests when it comes to forming a banking union.  And, no one seems to want to create a system of deposit insurance like we have in the United States. And, no one seems to want to bear the burden of forming some central regulation agency.  Without some give, somewhere along the line…nothing will happen!

The deeper problem is that banks are not seemingly resolving their balance sheet problems with the time given them by their respective central banks.  Liquidity has been pumped into both the United States financial system and the European financial system.  Yet, few banks seem to be lending indicating they are in a “holding pattern” until things get better.

Still, things have not gotten appreciably better.  If they had, Moody’s would not have had to downgrade all the banks they have downgraded…at this late date.

And, this applies equally to the United States banking system, where commercial real estate loans also plague many banks.

Furthermore, in Europe and in the United States, economic recovery is not going to take place as long as their banking institutions are not lending. 

To me, moving to a QE3 will do no more to right the banking system in the United States nor will a QE3 do anything more to help the economy start growing faster.  Just as in 1937, having more excess reserves in the banking system does not mean that the banks are solvent or that will start lending.  Other things must happen for the banks to start lending and one of these things is to honestly recognize the serious weaknesses that exist within the banking system and continue to re-structure the banking system as smoothly as possible so as to bring solvency back to the industry.

And, this is true of Europe.  Further provision of liquidity to European banks is not going to help them.  European officials, as well as the banks themselves, must accept the reality of the situation and move on.  The banking system needs bailing out.  Several governments in Europe need bailing out.  Solvency is the issue.  Recognizing this and re-structuring their societies is necessary to move forward into the future. 

Any bright future for Europe will only face further delay by postponing the re-structuring that ultimately needs to take place.      

Spain: Is This The Start of Something Big?

“Spain on Saturday agreed to accept a bailout for its cash-starved banks as European finance ministers offered an aid package of up to $125 billion (or €100).”

Note: this is for the banks only…not for Spain, itself…

The IMF had suggested that the minimum needed to stop the drain at Spanish banks was around $46 billion.  So, for once, it seems as if the finance ministers are finally trying to get their arms around the problem and not just “kick the can down the road”. 

After what we have seen over the last three years of so, it is easy to be skeptical.

To raise the credibility of the officials in the eurozone, this effort is going to have to be followed up by something more. 

Yes, the agreement has not really been signed and sealed yet, and I am looking further down the road. 

That, however, is the only way that credibility is going to become established.  One still shudders at the lack of leadership that exists within this community.

But, next steps are going to have to be made and they are going to have to follow right on the heels of this effort to halt the decline of the Spanish banking system.

The next steps are going to have to strongly indicate that the eurozone is following up this action with a real effort to create a European Banking Union!

This will not be a simple task, by any means, but it is the next thing on the agenda.

Yes, Europe needs a new unified fiscal authority to keep the eurozone together and to stabilize the euro.  This will be an even greater task than the building the European Banking Union.

The banking system needs to be saved first and this must be done in the short run.  The fear of a run on European banks seems real and this fear must be dealt with before we get to the sovereign debt issue.  Thus, full attention must be given to the issue of a banking union for it is the short run issue of consequence right now!

A major issue that will overshadow much of the debates relating to the creation of a European Banking Union is the giving up of sovereignty over banks that now reside within national jurisdiction.  That is, each individual nation in the eurozone is going to have to give up something very dear to them in order to achieve the creation of a banking union.  This surrender involves centuries of history, pain, dislike, and, in some cases, outright hatred.

Can the officials get over this hang-up?  Can they put the past behind them in order to save the future? 

Creating a banking union, however, is just the start.  If there are national issues that must be given up in creating a “federal” banking union, these issues pale when one considers what these nations must give up to create a “federal” government that oversees and controls the spending and taxing and so forth that have formerly been completely under the control and oversight of the individual nations themselves. 

But, it seems to me that there is very little to choose from in the present situation.

Let’s consider three possible outcomes from the current state.  First, a European Banking Union is formed followed by the formation of a federal European government that oversees and controls spending for the eurozone. 

Second, the eurozone falls apart and the individual nations now making up the union go on their merry way.

Third, some nations form a banking union and a federal government and other drop out of the community.

To me, the suffering and pain that would accompany the second and third choices would be very substantial.  The second and third options are just not pretty!

But, human beings can be very self-destructive at times and make choices that are stupid and against their own best interests.

In my mind, there is no real choice.  Somehow, someway, European officials are going to have to form a European Banking Union and are then going to have to follow this up with some kind of federal government that deals with the combined fiscal issues of the eurozone.

Therefore, I am pleased to see the discussions concerning the rescue of the Spanish banks going forward.  I am hopeful that these discussions will be followed up by the formation of a European Banking Union. 

Then, the big task…a federal European government that will discharge the responsibilities of the eurozone with respect to the fiscal affairs of the community.  Of course, this federal government will also have to deal with the restructuring of economies, work-rules, pensions, and so forth.

Seeing real, credible movement on the part of European officials, I believe, will be seen positively by international investors.  If these investors react positively to the movements to create a European Banking Union and then to the further efforts to create a federal European government, I believe that financial markets will rise and this will provide the support and encouragement for the project to continue. 

If this process gets started the European officials must not let the momentum or the international investment community will lose heart and argue that the officials were not fully into the idea in the first place.  Skepticism will set in again.

I see the possibility of getting started on the European Banking Union, however, as a real opportunity.  The issues here are not as great as those connected with the formation of a federal European government.  So, this is a chance to start on issues that are smaller and are clearer. 

The important thing is to get the process jump-started and then build on the momentum.      

The Bad News Continues: German Banks Downgraded

Moody’s has been traveling around Europe over the past four weeks or so and leaving its mark about everywhere it has gone.

On June 6, Moody’s lowered the credit rating of six German banks and three Austrian banks. 

Deutsche Bank was not included in this round of downgrades for it will be examined later this month when Moody’s does a review of the “biggest global banks” with large capital market operations. 

The latest round of bank downgrades followed three downgrades in Sweden on My 24, sixteen downgrades in Spain on May 17, and twenty-six downgrades in Italy on May 14.

The news release that accompanied the June announcements stated that the German banks still had a large exposure to structured credits, a substantial exposure to peripheral countries in the eurozone, and exposure to industries that were going through hard times, like shipping and finance. 

In addition the banks still faced a great deal of exposure to possible loan charge-offs due to weak profitability. 

And, these banks had only small amounts of capital relative to total assets.

The weak profitability can be attributed to the fact that German banks…and European banks in general…are not expanding their lending.   On reason is the reality of the current recession taking place in Europe.  However, with weak capital ratios and additional regulatory pressure to re-capitalize, the banks are not in any mood to move more aggressively on the lending front. 

The whole re-capitalization issue is also caught up in the discussions about forming a European banking union that would make almost all banks in the eurozone, European, and not just a member of a particular country.  This is not a non-issue!

And, if the banks are not lending, it will be difficult to achieve faster economic growth. 

One can see why the issue of a possible bank run on continental banks is being tossed around.  And, one can see why European officials are concerned.

The problem here is that if one ignores a problem for a long, long time, the problem does not necessarily go away.  And, in many cases, the problem can get worse.

The banking situation is Europe has been ignored for a long, long time and combined with the sovereign debt crisis, which was also ignored or action was postponed for a long, long time, things got worse. 

The added problem is that when things get worse, the solution is not always the same as in situations where the problem did not get worse.  And, when the problem gets worse, it often takes a much longer time for things to get back to normal. 

Liquidity actions on the part of central banks and deficit spending on the part of national governments may resolve a “more normal” banking or “more normal” sovereign debt problem within a reasonable period of time.

When the problems become ones of solvency and bankruptcy, the “more normal” prescriptions to solve the problems may not work and the time to return to “business-as-usual” may be an extremely long time.  But, when the problems become this great, officials often deny them and try to postpone getting to the real core of the issue for as long as they can.

We have seen this situation evolve in Europe. 

Now, the solutions have become structural and the potential disruptions to the existing culture have become enormous.  Where all this will end is unknown.

But, the pressures to act are growing.  Everything seems to be culminating in the need for eurozone officials to do something.  Financial markets react to news about what officials seem to be doing.  If it looks like the officials are moving to resolve an issue…financial markets improve.  If it looks as if the officials are deadlocked due to irreconcilable differences…financial markets tank.

Economic news does not do that much to move the markets these days.  The conditions of official discussions are the primary thing that the participants in the financial markets seem to be focusing upon.

Here again is another factor that arises when action is postponed.  The news never quite seems to be positive.  The German banks have been downgraded today.  Moody’s will soon have a report out on the “biggest global banks.”  And, then there will be something else. 

I know that the nations of the European continent have issues with one another that go back centuries.  I know that it will be very difficult for many people to lay down these issues and get on to what is real.  But, all I can say to the officials in Europe is…GET OVER IT!  Get on with business. The rest of the world cannot wait for you to fight another world war…if only on the conference table.          

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!