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!    

The European Banking System

The banking system in Europe, particularly in Spain, is getting a lot of attention these days.  The specific case that has been in the news is that of Bankia, the fourth largest bank in Spain.

Bankia is a special situation in that it was a consolidation of seven Spanish savings banks in December 2010.  It is obvious now that those involved in the consolidation basically put the banks together without recognizing the serious condition of the loan portfolios of the combining savings banks. 

The fact that the “hole” in Bankia’s balance sheet is so bad just highlights the incompetency of the Spanish banking authorities or their naivety given the serious state of the housing market crisis that Spain was undergoing at the time. 

Here again, one wonders what role the European interpretation of the financial crisis played on this restructuring of the seven savings banks into one.  If one assumes that the asset problems of the banks were connected with the liquidity of the loans, then, I guess, one does not feel that the value of the assets need to be written down.  If one were to assume that the asset problems were ones of insolvency, then the authorities should have responded in a different way. 

Europe, unfortunately…and incompetently…assumed that the problems faced by the banks were liquidity problems and not insolvency problems…and they just “kicked the can further down the road.”

“Can kicking” time seems to be over.

Now, however, the fear factor seems to be spreading beyond Spain to the rest of the European continent.  “A fierce debate is now taking place as to the best way to avert a run that, if it started, might be difficult to contain and could lead to massive capital flight from the Eurozone’s peripheral countries…”

Proposals for a banking union that includes integrated financial supervision and deposit insurance have been flying around Europe last week.

These proposals have been accompanied by increased calls for a “full economic and monetary union.”  But, again, this comes at a time when Greece may elect a government that rejects the agreed upon bailout provisions and at a time when Spain may also require a huge financial bailout to save not only its banking system but also its sovereign debt.  The rest of Europe may not readily accept either of these outcomes.

The difficulties faced by officials in Europe (I will not use the term “leaders” because I see none) are highlighted when put into contrast with the banking situation in the United States.  Although in the United States, Ben Bernanke and others at the Federal Reserve talked about the “liquidity” problems of the financial system, they were faced right away with solvency issues. 

The most prominent of these was, of course, the case of Lehman Brothers Holdings Inc., which filed for bankruptcy on September 15, 2008.  However, the Federal Reserve System and the Federal Deposit Insurance Corporation were faced with many, many more bank failures and bank consolidations soon after.  All told, since September 30, 2008, the number of institutions in the commercial banking system of the United States has dropped by 884 banks!  This is not an insignificant number.

In my opinion, the Federal Reserve ran its Quantitative Easing 2, at least in part, to help keep troubled commercial banks open and allow the FDIC to work with the banks in the worst shape to close or to find someone to acquire them in the smoothest and least disruptive manner possible.  In this the American regulators have been tremendously successful. 

Commercial banks have not really been giving out loans over this time period and hence help to underwrite the economic recovery.  But, the consolidation of the banking system has proceeded without much fanfare and this is not all bad!  At a bare minimum, this approach has provided some downside protection in the tepid economic recovery now taking place, protecting against any major disruptions from a cumulative closing of many banks within a short period of time.

The European situation seems to be going the other way.  Officials not only treated the banking situation as one big liquidity problem it added to the problem by forcing the European banks to take on more and more of the sovereign debt of the teetering peripheral countries of Europe.  Since the debt of the troubled European nations were assumed by European officials to be “riskless” the “troubled” banks could acquire the debt of the “troubled” European nations without suffering any decline in their existing credit rating.  

Thus, suspicious credit was added on top of suspicious credit at these banks.

And, the regulators went about their merry way without raising any kind of question or doubt about the solvency of these banks!  How blind can one be?

Then stress tests were administered…twice…by these same regulators in order to reassure depositors and investors of the soundness of the banks.  The stress tests were a “bad joke”.

As a result, “Since national regulators have lost the confidence of markets, they are having to bring in outsiders to assess how much capital their banks need.”  But, this could be a disaster if they are realistic and truly trustworthy.

Now, the authorities have to scramble.  The European Union not only does not have the fiscal authority to oversee the fiscal affairs of the member countries and the EU as a whole, it does not have a unified banking authority to oversee and regulate the banking activities that go on within the EU. 

It looks as if the anxiety in Europe is rising.  Mario Draghi, in the words of the New York Times, has issued a challenge: “A Terse Warning for Euro States: Do Something Now” The Times article goes on to say “The note of frustration and urgency in Mr. Draghi’s voice was a sharp contrast to six months ago…”

It is time that someone listened!

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?