Friday, November 28, 2014

The European Banking Union?

MUNICH – In blatant violation of the Maastricht Treaty, the European Commission has come forward with one bailout plan after another for Europe’s distressed economies. Now it wants to socialize not only government debt by introducing Eurobonds, but also banking debt by proclaiming a “banking union.”

Socializing bank debt is both unjust and will result in a future misallocation of resources. Socialization of bank debt across borders implies that a country’s private borrowing costs are artificially reduced below market rates, as insurance (in the form of credit-default swaps) is provided free of charge by other countries. Thus, capital flows from the core to the periphery would continue to exceed the optimal amount, undermining growth for Europe as a whole.

History offers countless examples of the misallocation of resources that can result from socialization of bank debt. One is the 1980’s savings and loan crisis in the United States, which cost US taxpayers more than $100 billion. Under the umbrella of common deposit insurance, US savings banks made a “gamble for resurrection” – borrowing excessively from their depositors and lending the money out to risky enterprises, knowing that potential profits could be paid out as dividends to shareholders while potential losses would be socialized.

In other words, private profits were generated out of socially wasteful activities. And essentially the same happened with US subprime mortgage lending and with the Spanish banking system in the 2000’s. In both cases, banks took excessive risks in the expectation – eventually vindicated – that governments would bail them out.

Spanish banks speculated on a continuing increase in real-estate prices, which would bring large capital gains to their customers. Indeed, they often lent homeowners more than 100% of the underlying property’s value. To compensate for the damage that their reckless behavior caused, they received €303 billion ($378 billion) in extra credit through Target, the European Central Bank's interbank payment settlement system, and can now expect a further €100 billion in help from the European Financial Stability Facility. Much of this money will never return.

Debt-equity swaps would be a much better way to recapitalize the banks. Rather than imposing the costs of the ECB’s and EFSF’s losses on European taxpayers, the banks’ creditors could give up some of their claims in exchange for receiving shares from the banks’ owners. Debt-equity swaps rescue the banks without rescuing their shareholders.

Ideally, bank creditors would not lose money, because their fixed-interest claims would be converted into bank shares of similar value. This would be the case as long as the banks’ losses remained smaller than their equity capital. A true loss would be inflicted on a bank’s creditors only if the write-off losses on toxic mortgage loans exceeded the bank’s equity. But, even then, it would be better for creditors to bear the loss than for taxpayers to do so, because this would encourage more cautious lending in the future.

Socializing public debt is already posing a risk to the still-stable eurozone countries. To do the same thing with bank debt could pull hitherto sound economies into the abyss, because bank’s balance sheets are much larger than the volume of government debt. In Spain, the public debt-to-GDP ratio is 69%, but the debt of the Spanish banking system totals 305% of GDP, or about €3.3 trillion – about as much as the combined public debt of all five crisis-stricken eurozone countries.

While the enormous volume of the bank debt implies that governments should shy away from socializing banking risks, it also suggests that only the banks’ creditors could reasonably be asked to foot the bill without being overburdened. Indeed, if, as some believe, only a fraction of the banks’ equity is at risk, the potential debt-equity swaps would be minuscule.

Spanish banks have 7% equity capital on average on their balance sheets. Thus, a debt-equity swap of less than 7.5% of the creditors’ investment would be enough to compensate for the banks’ losses. And, even if the banks’ private depositors, whose claims are 39% of the aggregate balance sheet, were excluded, the debt-equity swap necessary to compensate for a loss of up to 100% of the equity would be less than 12% of the creditors’ investment volume.

Debt-equity swaps have been used successfully in many cases, and they follow from normal bankruptcy procedures. Apart from avoiding the excess burden and injustice of taxation, they also have the benefit of inducing banks’ owners to choose a prudent investment strategy, while persuading creditors to scrutinize and select carefully the banks to which they want to lend.

The care taken in augmenting and preserving the wealth that current generations inherited from their ancestors is the ultimate reason for economic growth and capitalism’s success. Massive government interventions during the crisis have undermined this principle, and have probably already destroyed much of the inherited wealth.

It is time to heed the fundamental laws of economics and put a stop to the imprudence that those charged with fighting the crisis have been allowed to get away with. Europe needs no banking union beyond a common regulatory system.

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

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    1. CommentedErnest Dautovic

      I am wondering if the current german sovereign rate is driven by market fundamentals or by market fears, i am also wondering that if someone is speaking about Bank Union probably the issue is much bigger than a plain debt-equity swap. I am also wondering that we have witnessing 2-3 years of appaling incompetence by all sorts of EU policy makers, at both national and pan-European level. I much agree with the need to let some banks fail restoring a tiny bit of creative destruction in our financial system, unfortunately I also believe that the issues involve too many losses and contagion effects that this is not a viabla solution. And I have a final and simple desire that would solve, i believe, most of these issues: "repeal the no bailout clause" which only contribution is to make room for the financial markets to speculate and test the limits of the ECB. Euro zone is a bunch of countries without a lending of last resort guarantee, this is anachronistic and inefficient.

    2. CommentedThomas Lesinski

      I guess you mean the GERMAN banking system, which invested abundantly in US MBS and real-estate development in the euro periphery, and was merrily bailed out by the German taxpayer.

        CommentedDaniel Gomes

        German tax payer my rear end!

        Germans contributed with an infinitesimal portion of the bailout of its greedy irresponsible banks who cratered the world economy (including that of southern European countries) and I bet a great deal of it was offset by the taxes those banks paid during the golden years of subprime speculation.

        This article containing information forcefully disclosed by the Fed says it all.
        Geman banks were some of the major delinquents in the U.S. subprime derivatives crisis, greatly contributing for the cratering of the world's economy and for the piling of the debt of many countries due to the then required economic stimulus, lost tax revenue, and social welfare.
        And as a reward they received the mother of all bailouts:

        But this was not all, the Fed still rewarded these these financially disciplined Germans with plenty of cheap cash:

        Against worthless collateral:

        And as obvious, guess who was cut off from the credit markets in 2008 to 2009 and was not subdued into taking high interest loans under forced austerity?

        Now on top of these there are still the dollar swaps and the ECB money which we do not know because the fuehrer only wants to disclose information that benefits the superior interests of the arian race like the German 15% contribution for the so called bailouts (at loan shark rates).

        Nevertheless even discarding the billions received from the ECB the picture we see here is very obvious.

        We have hypocritical financial German prostitutes who socialised a stratospheric amount of their debt and now come and claim they are virgins who do not want to socialise the debt of other countries.

        For those who prefer facts instead of German supremacist rhetoric please study these documents from the Federal Reserve website and comment:

        Why don't German banks socialise their profits during the golden years of the subprime, a large chunk of which were given to German government in taxes on the repatriation of their profits?

        If German finances are so solid why is that Germany does not return at market value, the freebies it received?

        Also it's time to demand transparency from the ECB, I, a citizen of the Eurozone, demand to know how much money have I gave to German banks since 2008!

    3. Portrait of Asgeir B. Torfason

      CommentedAsgeir B. Torfason

      Debt-equity swaps have also been used unsuccessfully, most recently in late September 2008 by the central bank of Iceland taking 85% equity share in one of the three biggest banks. Within ten days all the three banks were bankrupt as well as the central bank technically and the whole banking system of the country had to be re-established. The cost was shared between taxpayers in Iceland, equity owners and creditors, like big German banks. In the case of Europe, the banking system is so big, and there is no big outsider that can absorb the credit losses, so I would strongly advise against testing this.

    4. Portrait of Asgeir B. Torfason

      CommentedAsgeir B. Torfason

      It is not clear that the cost of ECB's losses will be borne by European taxpayers. Of course if the central bank goes bankrupt the cost ends with taxpayers (like in the case of Iceland) but in the case of a successful ECB the losses could be absorbed by the central bank's future profits without any tax increase involved (except maybe a financial transaction tax, that I think most normal EU taxpayers are happy with).

    5. CommentedOrestis Aristides

      It is exactly this kind of thinking that got europe into the mess it is in. If these are the people behind german economic policy no wonder we are in such a state and no measures tough enough to tackle the european debt crisis are taken. A crisis that could undermine the political and social stability of europe without which any growth on paper is irrelevant.

      Having a common currency should we not have a common central bank? Yes? We do. Should this central bank not only act as regulator to banks working in the Eurozone but also be their lender of last resort? I believe it is important that incentives are brought in parallel.

      It is easy to be the regulator if you are not the one paying the cost should something go wrong.

      A complete redesign of the european banking system, where a single institution regulates, lends and bails out (with the ability seigniorage) the banks and is ultimately responsible for them while accountable democratically to the european public through (for example) the european parliament, is absolutely necessary.

      As a further note to debt equity swaps, I do believe there is a big future for these and that a great deal of de-leveraging is necessary in the banking system. But let us not forget that banks creditors are the deposits of ordinary folk. Which i am sure did not deposit their money in the bank expecting to receive stock. A major mistake that people in finance and economics make that disconnects them with reality is that everyone else is knowledgable of finance, that is not the case.

      Most people leave their money in the bank because they do not have the necessary means to invest it themselves. That is the purpose of the bank, to act as financial intermediary. And let us not forget that these depositors are usually the european middle class taxpayers, the ones that european institutions should protect.

    6. CommentedDaniel Gomes

        CommentedProcyon Mukherjee

        A stunning reference to the German Bank leverage by Mr. Gomes needs a careful scrutiny, as here we are dealing with some critical issues, which may not be that straight forward.

        There is no denying the fact that the German banking system takes on more leverage, led by Deutsche Bank itself with a leverage of 41 (Lehman crashed at 31).
        If one reads the treatise ‘What do we know of Capital structure?’ by Rajan and Zingales, one would see an apparent contradiction that the German non-financial sector takes on much lower leverage than the rest of the European and the U.S. system due to a plethora of reasons, higher bankruptcy costs, as the paper mentions could be one of the reasons.

        For financial firms and banks we have a complete opposite picture, with much higher leverage as a general rule, however leverage is strongly influenced by explicit (or implicit) investor insurance schemes such as deposit insurance; some observations are as follows:

        In Germany, banks are both allowed to underwrite corporate securities and to own equity
        in industrial companies. In the United States, significant limits are placed on both activities (see Kroszner
        and Rajan (1994), James (1994)). So when the German economy had been exploding and the non-financial sector had been doing well, the rise in leverage could well be balanced by this general safety net, the government however is the main backstop, in the event of any failure of any large bank. But surprisingly Deutsch Bank at the peak of the last crisis never got any direct benefit from the central bank or the government and waded through the crisis unscathed, which is no small achievement. It also improved liquidity and cash and its quality in the balance sheet right through the crisis.

        Deutsche Bank cut its net exposure to the sovereign debt of Greece, Ireland, Italy, Portugal and Spain to 3.67 billion euros at the end of last year from 12.1 billion euros in 2010, helped by hedging, write downs and maturing bonds. Deutsche Bank increased its core Tier 1 capital ratio, a measure of financial strength that takes into account risk-weightings assigned to various assets, to 10.8 percent by the end of 2011 from 7 percent at the end of 2008. Risk-weighted assets at Deutsche Bank will rise to 499 billion euros at the beginning of 2013 from 381 billion euros at the end of 2011 as new rules from the Basel Committee on Banking Supervision, Basel III, increase the value of the assets by 105 billion euros, Deutsche Bank’s ratio of common equity to risk-weighted assets using Basel III standards would be 7.4 percent by the end of this year.

        So the movement is in the right direction; do not know why such an extreme outburst against the banking system of the best performing economy of the world.

        Procyon Mukherjee

    7. CommentedDaniel Gomes

      Behold the arrogant hypocrisy of author and commentators disconnected from reality...

      Where are all of you including Mr Hans-Werner when in 2008 the FED and the ECB each in its own way pumped rivers of money into the dangerously over-leveraged banks of German and the Netherlands??

      Is your memory being clouded by your hypocrisy and stereotyping of certain periphery countries?

      Coming 2008 German banks were the most over leveraged in the Euro area and within that same euro area, they were the ones which required the ECB to SOCIALISE their debt the most, and where were all the financial responsibility virgin prostitutes back then?

      More than half of the banks accessing the 1% 3 year loan freebies from the ECB were German!

      Where were all you "property bubble" hypocrites when German banks like Commerzank went virtually bankrupt until the ECB saved them?

      Furthermore, the much discussed property bubble in Spain was not as artificial and profit driven as the property bubbles in which German banks got envolved and later rescued by the ECB.

      Spain's population grew by 10% during the so called property boom, furthermore it was also sustained by the retirees from northern countries looking for a winter home!

      The difference between German and Spanish financial system was that German economy continued to grow whereas periphery economies once viciously attacked by speculators and ratings agencies, contracted abruptly bringing the economy to a halt and with it the defaults.

      Sick and tired of reading arrogant Germans controlling the ECB as if its is their own Bundesbank and profiteering from the whole crisis while still complaining about "socializing of debt"

      The so called firewall to protect the German banking system from the periphery exposure was nothing but socializing of German bank debt and allowing them to shed the bonds of those countries sending them into a spiral which took the banking systems of periphery countries with them!

      And for once, refresh your memories, the banks of German and Netherlands were almost as responsible for the cratering of the world economy in 2008 as their US counterparts! ABN AMRO, DEXIA, Commerzbank!

      They started all this with their irresponsible behavior!
      The Greek, Spanish and Portuguese financial system was much healthier than the German and Netherlands back then!

      These over-leveraging risks were absorbed by each EU citizen through ECB which lends at 1% against any kind of collateral to save these banks but doesn't lend a dime to countries which fall victims of vicious attacks from speculators and ratings agencies!

      And the most cynical portion is that Germans know that this helps their banks but could never help periphery banks which are totally dependent of customers and credit ratings from countries in distress!

      So don't you dare now talking about debt socialisation when you're obviously another German supremacist who prefers to ignore the obvious facts to fit the theory of German financial discipline (the ones who scrapped the sanctions for countries violating the Maastricht criteria!

    8. CommentedFrank O'Callaghan

      A very clear statement. Professor Sinn has been providing the tools making clear the difficult situation for some years.

      The immoral and illegal actions of the bureaucrats who have conducted the management of our systems is rarely mentioned.

      The destruction of what he calls 'inherited wealth' and I would call long capital accumulation is important. It has been engineered by debt allocation. What the professor does not refer to is the question of who has benefited from this.

      In other writing he has pointed that self-regulation is nonsense but suggests that self-stewardship can work. This is not possible where losses are socialised. The current process of baying bondholders in full while wiping the shareholders is simply a discrimination within capitalism. That it is raised to a religious principle of the state is obscene. A debt for equity swap is far preferable to the common good and was implicit in the initial conditions of such bonds.

    9. CommentedZsolt Hermann

      The end of the article says:
      "...It is time to heed the fundamental laws of economics and put a stop to the imprudence that those charged with fighting the crisis have been allowed to get away with. Europe needs no banking union beyond a common regulatory system..."
      With this the only problem is that those fundamental laws of economics do not apply any longer.
      Understandably it takes a long time until we realize that we are at the most fundamental change in our history, and we are facing a situation we have no historical precedence, experience for. From a linear, polarized, "angular" world and development we suddenly transferred into a global, "round" world where everything is operating as a single network.
      Those "imprudent" people charged with fighting the crisis are not criminals, and they are not stupid. They do not find a solution to the crisis because there is no solution within the same framework the crisis was created in.
      As Einstein said: “Problems cannot be solved by the same level of thinking that created them.”
      We moved on from the system the previous economic and also social laws applied to and today exist in a completely new, global, integral, interconnected system. Our previous laws which served us reasonably well have turned destructive in this new reality.
      Any further development, solution for the crisis could only come from the full understanding of our new system, its conditions and laws, and how we ourselves can adapt to it.

    10. Commentedjracforr jracforr

      The Spanish banks did the same as was done in the USA, engage in reckless real-estate speculation that eventually went bust. This cycle has been repeated so many times before that it is comical . Because of the election in the USA, the world has entered the perfect economic storm,where lies and deception are being proffered as economic solution, by those who created this problem. Instead of forcing the speculator and their creditors to make restitution for the damage done, the countries economic problems have been attributed to ,workers pension , public sector wages and medical insurance etc. While these issues need to be addressed they are not the primary cause of the worlds economic problems. Instead banks are refinanced, because they are indeed, too big to fail. However as this article suggest Debt-equity swaps would be a much better way to recapitalize the banks in Europe as well as the USA. The government currently subsidize American banks with low interest rate loans which they lend at a profit. While this is sound policy in the present economic climate, it would be frowned up as socialism by the recipients, if this facility was offered to others. A distinction must be made between the free enterprise system and the predatory capitalism that landed the world in the present disaster.