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With Cyprus, Europe risks being too tough on banking moral hazard

Europe has long been far too tolerant of moral hazard in its banking system. But with the Cyprus plan, the pendulum may now be swinging too far in the

Publishing date
02 April 2013
Authors
Nicolas Véron

Europe has long been far too tolerant of moral hazard in its banking system. But with the Cyprus plan, the pendulum may now be swinging too far in the opposite direction.

This danger was made clear when Jeroen Dijsselbloem, the Dutch president of the eurogroup of finance ministers, rocked financial markets on Monday by hinting at a new doctrine that would put the full burden of future bank restructuring on creditors and depositors rather than taxpayers. In his words, “where you take on the risks you must deal with them, and if you can’t deal with them then you shouldn’t have taken them on”. This hardline stance echoes the memorable advice of Andrew Mellon, US Treasury secretary in the early 1930s, as reported by then President Herbert Hoover: “Liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate… It will purge the rottenness out of the system… People will work harder, live a more moral life.”

In July 2007, the opposite position was enunciated by Jochen Sanio, then Germany’s top financial supervisor. As IKB, a medium-sized German bank, revealed massive subprime-related losses, he argued that not bailing it out would trigger “the worst financial crisis since 1931” – an intentionally frightening reference. EU countries have since then implemented the “Sanio doctrine” by scrupulously reimbursing all creditors, including junior ones, of almost all failed banks with few and rather small exceptions in Denmark, Ireland and the UK. That this consistent dismissal of moral hazard originated in a German decision is ironic in light of later events.

Then change has come, gradually. In Deauville in October 2010, Angela Merkel, German chancellor, and President Nicolas Sarkozy of France announced that holders of euro area sovereign debt could face losses, but soon afterwards Ireland was still forbidden from “burning” senior bank bondholders. However, policy makers slowly realised that guaranteeing all bank liabilities reinforced a damaging “doom loop” between banks and sovereigns. In July last year, Mario Draghi, president of the European Central Bank, noted that “the question of burden sharing with senior bond holders is evolving at the European level”. Spain’s bank restructurings later that year imposed losses on many subordinated creditors. Earlier this year Ireland negotiated a deal that involved a loss for some senior bank bondholders. A largely silent revolution was instilling more market discipline into the financing of Europe’s banks.

This gradual shift was welcome. But in Cyprus it accelerated out of control, all the way to full “Mellon doctrine”. The island’s two biggest banks are now being liquidated, even though the process is administrative rather than judicial, with no government financial assistance. In an echo of Deauville, European leaders signalled on March 16 that deposits were no longer safe, after which the German finance minister Wolfgang Schäuble confirmed that deposit guarantees were “only as good as a state’s solvency”. This move annihilated trust in Cypriot banks and made the imposition of capital controls inevitable.

Just as the Sanio doctrine was made unsustainable by moral hazard and fiscal constraints, the Mellon doctrine is made unsustainable by the reality of systemic risk – today as in the 1930s. In fairness to Mr Dijsselbloem, he acknowledged that governments may not impose full financial discipline “in times of crisis”, but then implied that we are in no such times right now: a heroic claim. Governments have a responsibility to protect their citizens from catastrophic meltdowns. This is why a chastened US government had to bail out AIG, the insurance group, a day after letting Lehman Brothers go bankrupt.

As the US learnt the hard way, predictability is essential in such matters but also difficult to attain. Europe must now chart a path between untenable Sanio and unrealistic Mellon.

The trade-off is not only between moral hazard and systemic fragility, but also between national fiscal responsibility and European integration. The eurogroup’s new insistence that “all insured depositors in all banks will be fully protected” may or may not be seen as a form of “deposit reinsurance”, meaning that a deposit guarantee can indeed be stronger than a member state’s own solvency. But this declaration will have little impact on depositors’ behaviour unless a European backing of national deposit guarantee systems is made explicit.

Similarly, the insistence on orderly bank restructurings in an integrated market calls for a centralised process, which should be in place before the ECB conducts a comprehensive balance sheet assessment of all 150-odd banks transferred under its direct supervisory authority, a deadline now planned around mid-2014. The clock is ticking.

This article was first published in The Financial Times.

About the authors

  • Nicolas Véron

    Nicolas Véron is a senior fellow at Bruegel and at the Peterson Institute for International Economics in Washington, DC. His research is mostly about financial systems and financial reform around the world, including global financial regulatory initiatives and current developments in the European Union. He was a cofounder of Bruegel starting in 2002, initially focusing on Bruegel’s design, operational start-up and development, then on policy research since 2006-07. He joined the Peterson Institute in 2009 and divides his time between the US and Europe.

    Véron has authored or co-authored numerous policy papers that include banking supervision and crisis management, financial reporting, the Eurozone policy framework, and economic nationalism. He has testified repeatedly in front of committees of the European Parliament, national parliaments in several EU member states, and US Congress. His publications also include Smoke & Mirrors, Inc.: Accounting for Capitalism, a book on accounting standards and practices (Cornell University Press, 2006), and several books in French.

    His prior experience includes working for Saint-Gobain in Berlin and Rothschilds in Paris in the early 1990s; economic aide to the Prefect in Lille (1995-97); corporate adviser to France’s Labour Minister (1997-2000); and chief financial officer of MultiMania / Lycos France, a publicly-listed online media company (2000-2002). From 2002 to 2009 he also operated an independent Paris-based financial consultancy.

    Véron is a board member of the derivatives arm (Global Trade Repository) of the Depositary Trust and Clearing Corporation (DTCC), a financial infrastructure company that operates globally on a not-for-profit basis. A French citizen born in 1971, he has a quantitative background as a graduate from Ecole Polytechnique (1992) and Ecole Nationale Supérieure des Mines de Paris (1995). He is trilingual in English, French and Spanish, and has fluent understanding of German and Italian.

    In September 2012, Bloomberg Markets included Véron in its second annual 50 Most Influential list with reference to his early advocacy of European banking union.

     

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