From Bailout to Damage Control
The flood of recent contributions, and diversity of views offered, on the state of international banking and related policy issues left me with a growing feeling that the current debate about too-big-to-fail, rising capital ratios and separation of credit and investment banking goes in the wrong direction. Apparently, there is a widespread uncertainty and uneasiness about the current approach of international bank regulation and the impression that the measures now planned or taken will not make a fundamental difference sparing the international financial system neither the next crisis triggered by an irresponsible behaviour of the few and a combination of ignorance, fear and panic of the many nor the ensuing economic costs. Perhaps the time is ripe for considering some fundamental change.
Let us start with the current crisis in Europe. Whose crisis is it? Apparently, this is not a Greek (or Portuguese or Irish …) crisis, not even a European one. True, the Greek economy, to stay with the example, is weak and vulnerable in many respects. In this it does not differ from Asian countries in the 1990s and other crisis-prone economies worldwide. The same excuses and explanations why a country gets into the focus of international banks and capital flows are found here, too: Greed, corruption, tax evasion, “crony capitalism”. But, it is also true that ample capital in Europe and worldwide is wandering from region to region in search of profitable uses, and it is international banks and financial institutions which in carelessly trusting the European miracle lent the money they now fear not to get back. As far as those institutions are from Germany and France they are lucky to have strong advocates defending their interests – crony capitalism à la Europe.
Another truth is that Greece’s politicians lied and cheated in order to become a member of the eurozone – as did the leaders of all euro countries at that time. The fact that public debt figures – not only in Greece – were manipulated was widely known but European leaders deliberately chose to ignore it. In principle, with the first leaking of these practices Greek’s destiny as victim in the first big eurozone crisis, whenever it happened, was sealed. For Greece, Portugal, Ireland and others the euro promised growth and prosperity, money was cheap since risk-pricing mechanisms were out of order – and now the bill is presented.
Who is to be saved?
What would happen if Greece defaulted on its sovereign debt? The list of possible consequences is long – and most items concern Greece less than the rest of the world – ranging from bank runs and nationalizations in Greece over a political crisis in Germany to a global credit crunch. Beside heavily exposed Greek banks (most of which so far fared surprisingly well) and the ECB which holds Greek bonds as cash collateral the most obvious top losers would be French and German institutions as the following estimates show. Their involvement explains much of the nervousness of the international financial community since they belong to the group of SIFI (systemically important financial institutions) generally considered TBTF (too big to fail). The markets fear write downs, losses, contagion, and funding problems as the result of downgrades by rating agencies, up to a Lehman-style freeze of credit markets worldwide.
Barclays Capital estimated top foreign financial institutions exposed to Greek government bonds
Bonds and bills (€bn)
|Societe Generale (France)||
|Deutsche Bank/Deutsche Postbank (Germany)||
|DZ Bank (Germany)||
Perhaps the most dreaded effects are indirect ones. “Greek poses $41 billion risk to U.S. banks” announced a recent MarketWatch headline. Fact is that nobody knows the extent of involvement, and form of exposure, of US institutions which are still struggling to recover from the 2007/2008 financial crisis. Observers believe that most of their financial commitments are in form of credit-default swaps (CDSs) sold as insurance to European banks.
Rumours about the effects of CDS exposures abound although a look at the data shows that these may be widely unfounded: Currently, gross notional risk exposure on Greece is about $78 bn – a huge sum which is about 26% of outstanding bonds. In contrast, net notional exposure – the amount due if all bonds defaulted at the same time – is only about $5 bn or 2% of bonds outstanding indicating that there were both buyers and sellers of CDSs which in turn means that beside possible losses there are also gains to be expected from a Greek default. Furthermore, outstandig exposures are supposed to be reduced by collateral and margin calls. In addition, net notional risk has declined markedly since the beginning of the crisis being 28% lower than a year ago. By comparison: Net notional amounts of CDS outstanding for France, Germany and the US are about $20 bn, $16.5 bn and $4.5 bn respectively, with (partly strongly) rising tendency. As so often in financial markets it is not the fact that counts but expectations fed from many sources of varying reliability. Currently, the biggest concerns relate to the question where in the system losses would emerge in case of default and what kind of chain reactions these would trigger.
For Greece, the logic of default boils down to the question of illiquidity or insolvency. The general view by bond holders, including the ECB, is that as long as the country has assets to privatize it has only a liquidity problem. Michael Hudson compares this situation with a home owner who losing his job is no longer able to pay his mortgage. If he were considered merely “illiquid” the bank would only be too willing to lend him the money needed. However, as a rule, he would be considered insolvent and forced to sell the house or see the bank foreclose.
For Greece, default may be a sensible alternative and Alen Mattich in the WSJ rightly asked: What if Greeks decide they don’t want to be rescued? If it were for Greece alone, probably the international community would not care. To cite Deutsche Bank CEO Josef Ackermann: The risk of a Greek default lies in “what is going to happen in other markets and … other countries.” In the current situation the stability of international financial markets and the survival of the eurozone are at stake. Furthermore, the world financial system is not prepared to digest another demonstration of TBTF before a solution for this problem has been found.
Too big to fail?
How and when did the too-big-to-fail debate came up in earnest? Was it with the Lehman bankruptcy in September 2008 whose dimension shell-shocked politicians and regulators alike? Can it be traced back to LTCM and Enron in 2000/2001? Or did it start already with the end of the bubble economy in Japan in the 1990s that – at least in the view of Japanese observers – made the US subprime crisis look strangely familiar (Gillian Tett, Ch. 12)?
Fact is that over a comparably short time span the world of finance was confronted with a whole series of big bank failures with devastating economic effects reminding it that first and foremost international banks are like all transnational corporations (TNCs): intransparent and far out of reach of policy influence. Each time crisis struck, politicians and supervisors were caught ill-prepared and stunned by the diversity of activities, and dimension of networks involved, painstakingly acquainting themselves with the functioning of financial instruments and constructions that were invented to boost returns in times of monetary easing and low interest rates and circumvent official regulation.
Transnational corporations have become the symbol of globalization for both proponents and critics. In coordinating and controlling operations in a large number of countries as parts of wide industrial and financial networks, circumventing markets by strongly relying on intra-firm business, and international sourcing of intermediate inputs, and involved in webs of highly flexible collaborative relationships and strategic alliances with others worldwide, they create a “mismatch” between the political and the economic realm, as Wolfgang H. Reinicke put it, which is a constant challenge to the sovereignty of nations.
Banks which have long been regarded as footloose industry and forerunners of the globalization process offer a classic example of this mismatch. Favoured by developments in information and data processing technologies in recent years they became more and more flexible in reacting to a changing environment. They create ever new non-balance sheet instruments, shift between financial assets, relocate activities between time zones or from one place to another, to offshore centres or virtual market places, and move positions to related nonbanks such as special-purpose vehicles (details here, Chapter 6). The networks they built are widely perceived as transmitters of disease-like contagion and as instruments to disguise malpractices, exploit otherwise non-accessible profit opportunities and circumvent official regulation.
All TNCs are too big to fail. In principle, their size, diversity and networks are desirable characteristics adding to the firms’ strength which is beneficial to them and to the world economy. This holds in particular for financial institutions which provide the lubricant for keeping the economy going. Several years ago, there had been a debate in academics about the way in which the incompleteness of financial markets may hamper economic development. Although sounding like mockery in the context of the current crisis where observers feel there were rather too many, and too complex, markets there were lessons to be learned from the missing-market debate. In general, weakening firms by limiting their scope of action, superficially establishing firewalls and ringfencing activities risks falling back to a suboptimal state. However, size also bears the danger of excesses which is the greater the less responsible firms are held for their decisions.
In the contemporary global system a big transnational corporation going bust is a rare and incalculable risk. There are very few possibilities to shelter a national economy from its effects and usually governments cannot avoid at times to become involved in dramatic emergency actions. Provisions include the national and multinational setting of a legal and institutional frame for business practices and, if worst comes to worst, a wide range of measures to mitigate the effects on the economy and on those who are directly and indirectly affected such as employees, customers and creditors. However, as a rule, risk provision is understood to be in the responsibility of the individual firm. Direct policy interference in entrepreneurial risk management is considered neither practicable nor sensible, and the aim of emergency actions is not to save a poorly run company by all means but to limit the economic damage.
The traditional argument for the prevailing system of financial regulation is that banking is different. Banks fulfil a special economic role. Their liabilities are used as money and the state is called to secure confidence in the capacity of money to retain its value in order to serve as means of payments and denominator of contracts. Another argument is that in maintaining low ratios of cash to assets and capital to assets relative to short-term debt banks are particularly vulnerable and exposed to the danger of runs. Further, contagion may affect whole economies and bring the system to the brink of collapse. This is the rationale behind the proposal of major central banks that systemically important banks should hold an extra 1 to 2½% shock absorbing Tier 1 capital on top of the Basel III ratios. In this context critics point to the case of Bear Sterns: Once investor confidence is lost it does not help a firm to plausibly argue to be well capitalized.
The Bear Sterns example shows the weakness of the current regulatory approach. To cite Bethany McLean:
“The very situation in which a bank most needs a lot of capital is when investors start to suspect that the bank might be lying about the value of its assets. At that point, no amount of capital is enough.”
Trust is what matters most in financial markets, and improving trust and the general environment for containing an overall loss of confidence and spread of panic is the biggest challenge authorities are facing these days. In principle, big transnational corporations have their own ways to manage a sudden loss of trust and reputation without official assistance. Examples are the reactions of firms to massive environmental und human rights campaigns in recent years. But, again, banks are different.
On the one hand, the effects of a loss of confidence are more severe in banking than in other sectors. There is nothing comparable to a bank run in manufacturing. On the other hand, the traditional privilege of operating with a safety net spoiled the financial institutions in a way that apparently weakened their ability to contain, or only to consider, reputation damage – let alone fundamentally change their practices. Even in the prevailing situation with the aftershocks of one big crisis still to digest and another looming on the horizon there are indications that the willingness in the financial sector to take risks is rising rather than declining. The current marked increase of CDS exposures to the US of 136% over the past year, 77% to France and 83% and 86% to Japan and China respectively, and the increased popularity of ETFs in low-liquidity, low-transparency asset classes and synthetic ETFs are only two examples.
The rapidly growing number and severeness of financial crises in recent years, the ever new ways banks find to circumvent official regulation and their obvious low responsiveness to official efforts to enhance financial market stability call for an alternative to the prevailing system of costly bailouts and rescue scenarios and for redefining the rules of the game between policy and finance. The alternative to futile efforts to restore the system from inside were to shift the policy focus from saving banks to stronger containing the effects of default on markets and economies and on the wider economic and social environment. Signalling a strict decidedness to abstain from bailouts and limit policy interference to containing the social and economic damages of default, and acting respectively, could stabilize expectations and build up trust – not in the banks but in the economic and political system to manage crises thereby regaining some policy room for manoeuvre that has been lost in recent years.
The Greek example may serve to demonstrate in an admittedly very simplistic scheme how the current regime works:
– With Greece’s adoption of the euro the spread, or difference in yield, between Greek and German government bonds, which serve as a benchmark, almost vanished. As one author put it: It is difficult to avoid the impression that default risk was underpriced.
– Mispriced risk offered windfall profits to international banks lending to the Greek government which were uncritically welcomed.
– As soon as the risk materialised interpretation of the scenario changed and is now no longer a matter between borrower and lender but has become a “country risk”, a “eurozone risk” and a worldwide “systemic risk” calling for national leaders and regional and international institutions to step in.
– The idea is that money is organised for Greece, not to promote economic development in order to enhance future solvency, but to enable the country to pay the banks not to make them suffer unnecessary from their earlier (questionable) lending policy.
– With official lenders stepping in, the Greek debt burden becomes more and more a public one.
– Financial involvement of governments and official institutions, however, is no acceptable longer-term solution. Greek debt must shrink. Therefore, an adjustment program is designed.
– At this stage, an entirely different group of actors becomes involved: ordinary Greek citizens. The main adjustment burden falls on middle class firms, employees and consumers with enough money to pick up part of the bill, but not wealthy or influential enough to evade paying.
– In the end, foreign official and private creditors will have their money back – or at least part of it -, many ordinary people will be worse off than before, some people will perhaps have become incredibly much richer and international banks have long turned to another playground.
Who would trust a regime where all this does not happen for the first time?
The proposal to shift policy focus in an offensive way from bank bailout to damage control in order to enhance trust as a shield against panic and runs does not mean to stand by and cold-bloodedly watch as the next big international bank goes bust. The proposal would call for a longer-term perspective which would not help Greece or other eurozone countries in the current crisis but better prepare economies to deal with future shocks. Measures could include strengthening existing, and designing new, mechanisms to support the financial system from outside in an effort to build up confidence – not in banks, but in the ability of the economy to digest a crisis. For instance, initiatives could focus on legal principles or the redefinition of lender-of-last-resort functions, but also think about preemptive emergency programs possibly including private-firm involvement. Research would be needed: What makes it so difficult to forecast the outcome of a Greek default? Why do some situations escalate to a full-grown crisis while other dangerous-looking scenarios prove manageable? Why do some societies seem more prone to bank runs than others as the example of several Asian countries indicates? What lessons can be learned from historical evidence? Is it possible to establish “circuit breakers” to slow down chain reactions and contagion?
The approach would explicitly accept, and communicate, that no firm is to big too fail. Investors and customers must become more aware that dealing with financial institutions as with any other firm is not without risks. Banks must become more aware that risk has a price which is not paid by society. Fraud must be called fraud and, in contrast to recent experiences (examples here and here), legal consequences must be quick and clear.
The idea to defy bailout is not new. At first view, such an approach could not be expected to find widespread acceptance. However, the same could have been said of other programs. Recent policy initiatives to abandon nuclear energy are an obvious example that even the unconceivable may find the necessary support if situations become intolerable.
In the years to come many people in Europe will work hard, not – as intended by the EU founders – to reap the fruits of integration into the common market, but to pay the bill left in the current crisis. At the same time, US citizens will struggle with the leftovers of 2007/2008. In Asia, countries which saw their economic achievements of years wiped out in few weeks and months in 1997/1998 have mostly recovered. With the current weakness of US and European markets and capital wandering anew in search of high returns the region may easily become a crisis victim once again. There is no doubt that then countries such as China and India, whose financial systems had been widely isolated the last time, would be hurt as well. International investors’ interest is already increasingly turning to Asian markets once again. It is no coincidence that two of the three largest ETFs worldwide are tracking emerging market indices and that synthetic ETFs are reported to be growing in some Asian markets.
A new banking culture is needed to halt the succession of crises and defaults. Actually, new banks are needed – not bad banks, not special purpose vehicles, but cooperative and responsible institutions which are perceiving themselves as part of the system and not constantly undermining it. Abstaining from official bailouts may initiate learning processes which may help.