Wednesday, November 26, 2014

Banking Disunion

BARCELONA – The line of credit to Spain from fellow eurozone governments may help to stabilize a fragile banking system, at least in the short term, but it is a missed opportunity. Spain’s banking crisis provides a perfect opening to move towards a European banking union.

In the medium term, help to Spain will merely reinforce the link between the sovereign and the banks’ problems, causing even greater fragmentation in the European banking market and pushing Spain closer to potential insolvency by increasing its debt burden. By contrast, a direct equity stake in Spanish banks taken by an appropriate eurozone investment vehicle would decouple bank and sovereign risk. It would represent a decisive step toward unified European banking supervision, which could imply easier liquidation of non-viable institutions.

Such a move would also contribute to banking integration if the equity stakes were eventually sold in an open EU-wide auction. The issue is whether such a vehicle, and the appropriate control mechanisms for assisted banks, can be established in a short time frame.

A banking union is a necessary condition for survival of a monetary union that is unable to implement a strict no-bailout policy for member countries. Such a union should be understood as a centralized bank supervisor, resolution authority (RA), and deposit insurance fund (DIF), at least for systemically important and cross-border institutions, as well as a unified rule book for prudential supervision. There are, however, four major issues that must be confronted in order to move ahead with such a banking union.

First, a significant degree of fiscal integration is required, since an effective European RA requires a burden-sharing agreement among countries. In the United States, the Federal Deposit Insurance Corporation (FDIC) resolves institutions up to a certain size and insures deposits for all banks. Failures of large banks must be addressed through intervention by the US Treasury.

In the eurozone, where there is no single Treasury, a DIF and RA should be financed with levies on banks, with a backstop agreed among the governments before a crisis strikes. Indeed, insurance cannot be arranged once a crisis has erupted, because solvent countries and banks will not, and should not, pay for insolvent ones. A European DIF would address the next crisis, but not this one, though a European RA could start functioning with funds from the European Stability Mechanism (ESM).

The second issue that must be resolved is the design of the DIF and RA. A case can be made that both functions should be integrated within a single agency, which should have three main characteristics:

  • Levies or insurance premia on banks should be calibrated to the perceived risk positions of institutions according to market indicators such as credit-default spreads. Flat premia would merely induce cross-subsidization of risky banks by safe ones.
  • Following the FDIC model, the agency should be bound by a prompt corrective-action procedure to avoid the regulatory forbearance that we have witnessed so many times in banking crises, from the Savings and Loan crisis in the US in the 1980’s to Japan in the 1990’s. Spain is the latest example.
  • The agency should limit taxpayers’ exposure by wiping out shareholders and subordinated debt holders if needed in a restructuring procedure. The idea that no bank can fail, and that no losses for bank investors are to be permitted, implies an unbearable burden on public budgets, as the case of Ireland demonstrates.

The third issue concerns whether the scope of a banking union should be the European Union or the eurozone. A banking union is not strictly necessary for a high degree of financial-market integration. Countries that want to participate in the banking union but not in the eurozone face a dilemma, because they will have to move toward fiscal union (via burden-sharing) even if they do not wish to join the euro. This dilemma is particularly stark for the United Kingdom.

Finally, a banking union is not sufficient for the monetary union to survive. Indeed, there is no European deposit insurance fund that could sustain a run on deposits in Italy. To cope with this type of sovereign risk, a high degree of political and fiscal integration is needed.

Europe’s financial crisis has led to a re-nationalization of banking systems across the EU, with bailout policies in countries like Ireland, Belgium, the Netherlands, the UK, and now Spain contributing to the trend. The ECB’s massive refinancing operations to provide liquidity to the financial system have also strengthened the link between sovereign and bank risk.

The naive belief that integrated European regulation and supervision would follow financial integration has proven to be false. There are now only two options: integrate ahead of markets – that is, give the ECB supervisory powers for systemically important and cross-border institutions, unify prudential rules, and create an RA with money from the ESM – or permit the current disintegration process to continue and await the euro’s relatively quick demise.

Read more from our "Sticking with the Banking Union" Focal Point.

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    1. CommentedGary Marshall

      Hello Mr. Vives,

      You don't sound hopeful of a resolution. Fiscal integration is needed, and there is a very simple way to achieve it.

      In conventional economics you are right -- Greece and the other troubled nations have no good options. But in progressive economics, they have a very good option: the abolition of Taxation. Absurd on the face of it, but not so when examined.

      Below is the very simple proof for this measure.

      If you or anyone can find the flaw, I shall be more than happy to give the reward of $50,000. None have yet been successful. Perhaps because so few have tried.

      Its not the end of the world, but a new beginning.



      The costs of borrowing for a nation to fund public expenditures, if it borrows solely from its resident citizens and in the nation's currency, is nil.

      Why? Because if, in adding a financial debt to a community, one adds an equivalent financial asset, the aggregate finances of the community will not in any way be altered. This is simple reasoning confirmed by simple arithmetic.

      The community is the source of the government's funds. The government taxes the community to pay for public services provided by the government.

      Cost of public services is $10 million.

      Scenario 1: The government taxes $10 million.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      No community government debt, no community
      government IOU.

      Scenario 2: The government borrows $10 million from solely community lenders at a certain interest rate.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      Community government debt: $10 million;
      Community government bond: $10 million.

      At x years in the future: the asset held by the community (lenders) will be $10 million + y interest. The deferred liability claimed against the community (taxpayers) will be $10 million + y interest.

      The value of all community government debts when combined with all community government IOUs or bonds is zero for the community. It is the same $0 combined worth whether the community pays its taxes immediately or never pays them at all.

      So if a community borrows from its own citizens to fund worthy public expenditures rather than taxes those citizens, it will not alter the aggregate finances of the community or the wealth of the community any more than taxation would have. Adding a financial debt and an equivalent financial asset to a community will cause the elimination of both when summed.

      Whatever financial benefit taxation possesses is nullified by the fact that borrowing instead of taxation places no greater financial burden on the community.

      However, the costs of Taxation are immense. By ridding the nation of Taxation and instituting borrowing to fund public expenditures, the nation will shed all those costs of Taxation for the negligible fee of borrowing in the financial markets and the administration of public

      Gary Marshall

        CommentedGary Marshall

        Hello Flip,

        Its comforting to see that I am not the only one who writes long posts.

        This is not an expenditure question. The post submitted only deals with how the government raises revenue for public expenditure, or rather how the government fills up its money bag, not how it empties it. I don’t know what you mean by a financial system having a surplus or deficit. The money would be borrowed in the financial markets for worthy public projects that generate returns exceeding all costs. I could not foresee a time when a nation could not borrow for a public expenditure that generates salutary returns. So I believe the question is irrelevant to the idea, but I shall let you explain further before fully answering it.

        And why could a nation not abolish Taxation and start borrowing its full public expenditure whether in good times or bad? The idea would generate massive financial returns especially for a nation of straightened financial means or crisis such as Greece or Ireland with their very high unemployment numbers and a stagnating or receding economy. It would be the perfect antidote for their ills.

        Communism is the prohibition of all private property. This idea makes no such demand. Private property shall flourish since the government can no longer take it by force or legalized confiscation.

        Only resident citizens will be able to lend to the government. That should take care of your argument about undue corporate influence, which thrives in a system of Taxation. And those citizens will lend on a basis of financial risk and reward. If the lender receives a suitable interest rate, he shall lend. If not, he shall find another borrower offering a better return. It happens all the time in financial markets.

        The Federal Reserve will not be able to lend to the Federal Government, nor any bank. So that influence that presently intruded into and perverted the financial markets shall disappear.

        Well, if the Federal Government presently takes in most revenues from taxes upon citizens and corporations, which are owned by citizens, there should be little financial effect. If government collection is $10 million before the abolition of Taxation, and $10 million afterwards, then what’s the difference? Its the same amount of money. Its purely a financial decision based upon the interest rate. If too low, the government will raise it to induce lenders.

        The government will continue to have its secrets, just far fewer of them. Would you lend to a government that squanders your money. Most won’t. Which means the government changes its ways, or it ceases to function. That is a good thing. The government will have to justify every expenditure. And if it cannot, then it doesn’t get the money. Certain things for reasons of national security may be disclosed partially or sparingly, but blunders shall come to light.

        There will be no more subsidies, which is pretty much squander of public resources. I have seen little evidence under Taxation that the government knows best how to pay its bills. Under borrowing or the public’s direct control of finances, things will greatly improve.

        Yes, the debt is here to stay as it always has been, but so will the sired assets and their accruing returns. Educated people will offer far greater returns to a nation than uneducated people, hence the need for an education system.

        The interest is borrowed as well.

        How do New Yorkers currently feel about sending money out of their state to other states for all sorts of Federal programs? With borrowing, there will be far less public expenditure at the Federal level, and far more at the local level. And there will be far more control exercised over the money expended by government in New York or elsewhere.

        I hope this answers some of your queries.

        Gary Marshall

        CommentedFlip Bibi

        What you also forget to explain is how will the government pay the interest to the loan. If the government needs $10million and it gets it from the people with an interest of Y, how will the interest paid once the $10million are dispersed to paid the bills? It's going to ask for another loan? Or collect tolls from highways that it just built? Those tolls are a form of tax, and chances are they will charge twice what it should so then people will find another way to avoid paying the tolls.
        For example here in the US, public schools are funded based on the property taxes, so if there is no taxation schools will start suffering, then what? Kids will be sent to better schools which will be private so following the laws of demand and supply: the higher the demand for private schools the more expensive they will be thus leading to more kids being under-educated which will lead to a lower class of workers. Alas, it is a downwards spiral.
        Consider also that people of New York want to have their money pay for what New York needs and not what San Fransisco needs. And assume a hurricane falls on Miami after the government has allocated the $10million; how will the government pay bills for the repairs? Another loan? The money will come from Miami or Denver? How will the people of Denver feel about that?

        CommentedFlip Bibi

        The only way for your idea to work, several conditions need to be applied. To start with, the country's financial system needs to be going through a surplus and not a deficit. Secondly, the whole industrial output ( tourist, service, industrial, etc) must be going through a period of growth through which investments are possible. And finally, the citizens should not be going through any form of bubbles nor through a period of unemployment. So just to start applying your theory is troublesome because the conditions needed to abolish taxation are difficult to obtain and in all honesty I do not know any country that has ever met, or ever meet those conditions. But once the criteria are met, the abolishment of taxes can be discussed, but a vast number of the population will oppose the idea because of one of two factors: a system as you discuss is the true form of communism in which people will depend on others to achieve what ever needs to be done and you know well what the Western countries think of communism. The second factor is that others will see the system as volunteerism. When a volunteerism system is in place, people will want to pick and choose where and how much of their money is given to the government and here many issues will arise, problems of corruption will be even greater within the government, corporate favoritism will be more rampant and corporate involvement in governmental systems will be more intrusive and not transparent.
        As you say, the government will tell the population how much it needs and at which rate the interest will be paid to the lenders, and if the bank actually determines the rate  it is in the banks interest to maximize profit and not to maximize lenders profit, and this will be be archived because the banks will be always favored by the government; hence favoritism; and if the government sets the rate, then it would do what it can to minimize its loss and maximize capital retention. 
        When dealing with a national budget, the amounts are extremely high. Do you really think that in times of surplus, there will be enough money to pay all the bills the government has to get accomplished? I think not. Not even in times of surplus people will be finding it in their hearts to lend money to the government, it is human nature to be greedy with what s/he has, and it is human nature not to trust any form of government. Take a good look around you, pick any country and you will see that there is always distrust between the population and the government. Look at the "Arab spring", look at China where people are fighting for democratic liberalization, look at the USA where the population can be divided into two groups (republicans and Democrats) unwilling to compromise with each other. Look at Greece, Italy, spain, France, Sweden, etc. no matter how transparent a government paints itself, it will always have its secrets. Could you see the American government telling its population that it needs $2billion dollars to upgrade the helicopters for the US Navy Seals? Remember that it is human nature to ask what/where their money is going to do and if they dislike what they hear then they will not lend the money. 
        The government has to tackle many issues that affect the population in more ways than one can think of, if the ability of a government is limited due to lack of taxation it will be hard for such government to come up with the money to pay subsidies  in order to keep commercial products at the reach of consumers. Without  subsidies, all product prices will be regulated by the markets, thus many products will be out of the reach of many; for example in the US, a gallon of milk is more expensive than a gallon of unleaded fuel; I wonder how much milk would cost if it was controlled by the markets? So here again, there are secrets that the governments do not wish to let know because it would make the population more skeptical of the government. 
        But what kills the idea of living in a nation which has abolished taxes, is the fact that the system will not last for long because of human nature. You see, many ideas look great on paper, but they always forget that humans behave as humans and that their behavior can not be predicted nor they are cyclical. Thus it is up to the government to determine the best way to pay its bills, and the only solution is through taxation, and the laws of taxations should be fair, equal to all, applicable, realistic and above all enforceable. All nations even during times of surplus will incur debt, because there is not enough money to do all what needs to be done by the government. A small or large debt is a debt, and all nations have it. The reality of life is that all the laws written down need to be applicable, fair and enforceable. Another reality is that debt will never go away, it is here to stay, as long as humans exist and work to live.  Economies would not work nor exist if debt did not exist, for debt, and credit, is what makes money make more money. 

    2. CommentedFrank O'Callaghan

      What is the unspoken issue? The bail-outs are to ensure that those who invested in banks have their worthless investments bought out at their full previous value. They were free to gain in the past when winning, but now that their bets are lost they are magically reimbursed by the population of Europe. The people of Europe gained nothing from the gamble but must now suffer to compensate losers in a casino.

      Inequality of wealth is matched by this inequality of casino capitalism. The rich must not be allowed to lose. The citizen must not be allowed to win. Insanity.

        CommentedMark Pitts

        Mr. O'Callaghan:
        Many see a quite different issue. Banks invested in good faith in the sovereign debt of their own countries. Now they may go bankrupt because the governments cannot or will not repay their debts. The insanity is the level at which the government class betrayed those who saved.