Blog Post

Europe’s banks still need restructuring

Whether in G20 summits or in more local venues, most current discussions on financial stability tend to focus on ensuring that last year’s meltdown does not happen again, with tighter regulation of capital and compensation policies, prevention of moral hazard through new resolution mechanisms, overhaul of supervisory structures, and reform of governance and disclosures. But […]

By: Date: October 27, 2009 Topic: European Macroeconomics & Governance

Whether in G20 summits or in more local venues, most current discussions on financial stability tend to focus on ensuring that last year’s meltdown does not happen again, with tighter regulation of capital and compensation policies, prevention of moral hazard through new resolution mechanisms, overhaul of supervisory structures, and reform of governance and disclosures.

But while Europe’s policymakers ponder how to prevent the next crisis, they should remind themselves that the current one has not been solved yet. True, the market is no longer in panic mode, and macroeconomic contagion has been successfully prevented so far in the EU’s more volatile central and eastern countries. But while some banks have started repaying state aid, the banking system remains largely under state guarantee. The latest numbers from the International Monetary Fund suggest huge losses remain undisclosed, especially in the euro area. And government finances are being stretched to an unprecedented limit.

Meanwhile, weak banks will keep financing weak companies to delay the day of reckoning, even in cases where it is overdue. Simultaneously, the economic agents which would extract most value from credit, especially companies with a potential for high growth, will not have access to it. Experience tells us that the resulting economic “zombification”, which is not only about credit crunch but misallocation of capital on a vast scale, has a powerful negative impact on growth.

We also know that the financial system will remain crippled as long as there has not been a system-wide ‘triage’, in which government authorities check the health of all large banks under a single methodology to value assets more reliably than in the published financial statements, share the result with all market participants – and take action if some institutions are too weak to be brought back to health by market solutions alone, let alone insolvent. Past examples, including the US savings and loan banks in the 1980s or Sweden in 1992-93 or Japan in the 1990s, illustrate that such triage is the key to exiting systemic banking crises. In the US, the “stress tests” of this spring have had a comparable effect. They have enhanced trust, enabled considerable levels of capital-raising, and are at this point considered by most observers as a resounding policy success.

A triage process is always politically difficult to initiate, as it differentiates winners from losers and can trigger the use of public money, though there was no such direct effect in the US case. In Europe, this difficulty is compounded by the mismatch between a basically integrated EU banking market, where competitive forces largely (if imperfectly) straddle borders, and supervisory institutions which until now have remained essentially national.

Integration is too advanced for nations to act alone: with economic nationalism running high, policymakers prefer a dysfunctional status quo to revealing weaknesses in some of “their” banks that would expose them to the risk of being taken over by “foreigners”. At supranational level, no player is strong enough to force action. The Committee of European Banking Supervisors (CEBS) has almost no power of its own. A European Banking Authority is planned to replace it and will probably develop some teeth eventually, but not before many years. The European Commission’s competition services are doing a remarkable job of forcing restructuring as a counterpart for state aid, but have no systemic stability mandate and are at risk of overextension. The result is, to a large degree, policy paralysis.
Just contrast the three-page results of the “stress tests” carried out by CEBS, released earlier this month, with the US communication back in May.

CEBS assures us that things are all right, but gives no bank-by-bank numbers, so the market cannot identify which institutions need more capital and how much. In spite of carrying the same name, the US stress tests delivered triage, while the EU ones do not. The latter seem not to have moved the market an inch.

Given the institutional mismatch, only political leadership can break this stalemate. Germany is the pivotal country here, being both the EU’s largest player and one where a number of major financial firms, starting with most Landesbanken, are believed to be financially feeble. But not coincidentally, Germany’s banking and political communities are uniquely intertwined. This has impeded bold action under the “grand coalition” that governed Germany until late September. Whether it can change following the recent election is a major question for Europe’s future.

If such change happens, then Germany would have enough heft to foster EU-level action. This could take the form of a temporary multi-country fiduciary entity to do the triage, broker any intergovernmental negotiations if joint interventions are needed, and manage those assets that would fall under public ownership as a result.

The good news is that contrary to some maximalist views, the crisis has taught us that the burden of such intervention can be shared among countries on an ad hoc, bank-by-bank basis. In other words, unity of action is required for successful handling of banking situations, but fiscal federalism is not. Just as the single currency has proved fairly resilient even in the absence of an EU federal budget, a credible supranational crisis management framework can be created without asking member states to abandon their fiscal discretion.

With this in mind, Germany’s options look fairly simple. Either it leads a triage process jointly with its neighbours, a difficult task that calls for unprecedented solutions but a necessary condition to restoring sound credit conditions. Or it continues defending sticking-plaster fixes that amount to inaction, with the price being sluggish growth for an unlimited period of time, as in Japan during the “lost decade”. Your choice now, Ms Merkel.


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