01 July 2012

Facing Two Real Pains of Europe: Weak Banks and Over Indebtedness

Look at it in one way or another: one of the most central themes in the eurozone crisis appears to be the weak banking sector. When put into the broader context, it is told to be the vicious circle / adverse feedback loop between weak government finances, weak banks, and weak growth. Citing European Central Bank Governing Council member Patrick Honohan: “Financial martkets will remain fragile until Eurozone governments manage to break the "vicious" feedback loop between banks and sovereigns.” (Source: Deutsche Börse Group, Market News International; 29 June 2012)

Most of the bankers and their immediate supervisors of course would stress the recent improvements in the capital adequacy and liquidity ratios, yet this improvement is from a very low level; the fact is that there is not much confidence left on the financial markets, and limited supply of new credits is an issue from macro point of view. Let’s face it:
1) the fair value of banks’ assets is unknown – one might easily guess that there is much “air” in the banks’ balance sheets, and no one really knows how much;
2) many if not most of the Eurozone governments, households and businesses are too over indebted for any new credit right now, and not only in PIIGS, but also in the very core of the eurozone;
3) depositors in some of the European countries are panicking;
4) because of the design of our financial and economic system, the economy cannot grow if there is no confidence and no new credit.
Here we are, in the middle of “contained mess”. 

This is what the IMF’s and Eurozone officials (with certain exceptions of Germany and Germany’s supporters in their public communications) have already implemented or agreed or strongly suggest concerning banks and monetary policy:
* Supportive/accommodative monetary policy, incl. low interest rate environment, purchasing government securities of the troubled countries and (preferably) the most direct way of quantitative easing;
* Granting banks access to virtually unlimited liquidity support;
* Re-capitalising banks if this should be necessary (incl. enhanced domestic backstops and use of centralized resource pools such as EFSF and ESM);
* Pan-European banking regulation, supervision and deposit guarantees; Pan-European bank resolution authority;
* Encouraging bank restructuring and consolidation possibly through an EU-level policy (incl. through FDI and foreign banks taking significant credit shares in southern countries);
* Moving towards single financial market / completing monetary union (incl. eurobills and eurobonds even though the German Chancellor Angela Merkel reportedly ruled out jointly guaranteed eurozone debt for “as long as I live”, a statement that was, ironically or not, welcomed with something like “we wish her a long life then”)
Each time when an agreement is reached in this direction, the markets breathe a sigh of relief and then... fall back.

For Mr. Market, no measure taken so far has been enough – and that seems (but only seems) to be one of the key troubles. Authorities are just about to lose their authority in the eyes of Mr. Market when it comes to calming down the ...hmmm, excitement about the asset (or liability) values for a longer period. The reason, as explained below, is that they actually still do not have a footing, even if all the proposed measures would be taken.   

For an ordinary citizen (by an “ordinary citizen” I simply mean someone whose main focus is not in finance; by no means the term refers to “less valuable” or anything like this), using tax payer’s money for supporting those who have behaved irresponsibly, policies that are bound to turn out inflationary sooner or later, helping the banks of stronger countries to “invade” credit markets of weaker countries and grow even bigger irrespective of the too-big-to-fail problem etc. cannot look anything else than counterproductive and unfair. What’s more? The political leaders are doing what they disapproved at the start of the crisis: inventing creative structures and strange vehicles such as leveraged EFSF for hiding tax payers’ real exposures. (My respect to Ms. Merkel in that sense: she dares to be against many things that are against common sense, and/or encourage irresponsible behaviour and living on the expense of the future – even though the logic of finance does not support her.) No wonder that we see social unrests here and there. After all, one does not need to be a cook in order to say if the soup tastes good or not.

Indeed, even though the proposed measures may be “helpful” up to certain extent, crucial issues still remain.

Why “helpful”? Because:
* Banks that are too big for an individual country do not look that big on European level. After all, the largest UK’s, US, Japanese and Chinese banks are as big as the largest eurozone banks; Europe wants to stay competitive in international comparison, right?
* Using the combined “fire power” of the ECB and the EFSF/ESM prevents markets from freezing, and keeps down the interest rates for the troubled “euro area periphery”. Eurozone as a whole is still in a pretty good health and almost (even though not 100%) can “print” itself out of the current debts.
* Pan-European deposit insurance should sound convincing enough for e.g. Greek depositors for not moving their money out of the Greek banks (which is a major headache for Greek banks right now: their stable funding base is literally escaping), even though the size of the deposit guarantee fund would most probably be insufficient for dealing with the failure of a large European bank. 
* The problem of the current over indebtedness is ultimately solved by inflating debts out and/or writing bad debts off (extensive liquidity measures, and offering banks better or worse hidden arbitrage opportunities and thus boosting their profits, as well as explicit recapitalisation of weaker banks would enable this).
* There is always an excuse for the electorate about banks being heavily regulated, strictly supervised and taxed.
“Helpful” is in quotation marks because the proposed measures are nothing more than an attempt to create another illusion of safety (only bigger this time). Fundamental problems and a fertile ground for the next crisis still remain.

Here are some crucial issues that largely remain unaddressed:
* Banks would still carry lots of crap in their balance sheets for quite some time. Markets would or should be assumed to continue panicking about this (simply take a closer look to the bankers “cookbooks” during good times; here is an overview of the Spanish recipe: Chapter from Banker’s Cookbook: Cooking Banking Books in Spanish Way*).
* The obscurity remains: at least an outsider would not have a fair idea about the true value of a bank’s assets and liabilities. There is still a risk of “discovering” a major loss, and government stepping in as a consequence.
* It’s far from being sure if the vicious feedback loop between the banks and governments could be broken this way.
* Too-big-to-fail problem remains, as well as opportunities (such as banks profiting from implicit and explicit public sector guarantees) and at least some considerable incentives for reckless behaviour. At best, stricter regulatory frameworks may cope with them only on a temporary basis.
* Monetary authorities and regulators can and do make mistakes too; their mistakes may easily prove to be too big now when the banking system clearly depends on their artificial life support.
* Rising overall indebtedness would still be a necessary precondition for the future growth; thus, even if the current “solution” works, we are bound to be back on the position not too different from the current one – and not in a too distant future. Sounds like not much progress, or what do you think? Have they run out of fantasy?

As you see, getting out-of-the box has become the absolute necessity. To be clear: “printing” more money and/or, even though on the quiet, sharing risks / unrecognised losses with more people / tax payers while creating false sense of security (e.g. as basically proposed by Perry G. Mehrling in the INET Blog in the frame of a thought experiment for disentangling banks and governments: “Lethal Embrace? A Thought Experiment”), is not out of the box – it’s still something within the box.

In one of my coming posts, maybe already the next one, I’ll discuss a feasible way forward that among others deals with the:
* Issue of too much debt when compared to the amount of money in circulation;
* Issue of market participants not being able to value banks’ assets, incl. government debts of the PIIGS;
* Too-big-to-fail (or save) problem;
* Issue of banks using depositors’ money and (implicit or explicit) government guarantees for gambling;
* Excessive dependence of the artificial life support by the governments and central banks;
* Identifying and unwinding factually insolvent banks immediately.
While not trying to solve everything once and forever / organise some kind of revolution / invent something completely new, I’m wondering why this simple option has not been really considered and discussed so far by the main stream. Have I missed something important or there indeed is no real intention to break out from the current vicious cycle? Maybe it’s just lazy thinking and/or limited knowledge about the current opportunities. Smart guys have observed that people are like crabs who are trying to climb on top of each other; we can go forward once we have recognised this.  

People are like crabs who are trying to climb on top of each other.

No comments:

Post a Comment