It’s feeling like 2007 all over again. The New York Times has a bizarre and prominent story (now the lead item on its business page) on how the lack of integrated bank supervision in Europe is causing a breakdown in interbank lending. Gillian Tett at the Financial Times covered this very topic three weeks ago, and the culprit for the caution over cross border funding is Eurobreakup risk, not the lack of a pan-European bankmeister. The New York Times (and the Wall Street Journal) getting it wrong when the FT gave straightforward, informed accounts was a frequent feature in the early phases of the crisis (both US papers upped their game considerably as the bad financial news increased).
Now the headline is accurate (“Worried Banks Resist Fiscal Union“), the main argument of the story is another matter:
The seemingly endless series of euro zone crises has European officials pushing for a banking union that would watch over and bind together the currency group’s faltering financial institutions.
Europe’s commissioner for competition, Joaquín Almunia. His patriotism was questioned when the Spanish-born commissioner recently said that at least one Spanish bank might need to be shut down.
But for Europeans, there seems to be little appetite for such a compact right now. In fact, banks and their national regulators, anxious about the Greek elections and Spain’s hastily arranged bailout, are behaving more parochially than ever.
That poses a threat to the interbank lending across borders that is crucial to maintaining liquidity — the free flow of money that is the lifeblood of the global financial system.
French and German banks have clamped off much of the lending to their counterparts in Italy and Spain, which in turn are primarily giving loans to their own debt-laden governments.
And in Madrid, even after European finance ministers agreed to a 100 billion euro, or $125 billion, rescue of Spain’s failing banks, the always proud Spanish government is insisting that it — and not Brussels bureaucrats — will take charge of how and where the funds are deployed.
Let’s unpack this. The reason interbank lending is a big deal is it is one of the ways that funds in countries that have high savings rates (e.g. Germany) get to the debtor countries (ie Spain). But the interbank system has been playing that role less and less as the crisis has worn on and the ECB has stepped in. A simple version of how this works from the Wall Street Journal:
Target 2 is a loan-settlement system for national central banks in the euro zone. Here’s (more or less) how it works: If you live in Spain or Greece and buy a German car, the money from your bank has to come from somewhere. In normal times, your bank obtains the funds in the interbank market.
In stressed times, the bank has to rely on the European Central Bank. So the national central bank in Spain or Italy or Greece builds up large liabilities to the rest of the euro zone. In Greece’s case it is nearly 100 billion euros.
Germany on the other hand is generating ever-larger credits against the rest of the Eurosystem. The Bundesbank’s claim against the ECB is nearly 700 billion euros.
Now why are banks not performing their normal role? As various reporters and analysts (Tett, Gavyn Davies, our Marshall Auerback, to name a few) have pointed out, the real reason is fear of a Eurobreakup. As Tett explained it:
Earlier this month, I asked the leaders of a group of US-based companies what – if anything – they were doing to prepare for “Grexit”, or a possible exit of Greece from the eurozone. The responses from the manufacturers were rather vague.
The bankers, however, were alarmingly precise: amid all the speculation about Grexit, they told me, banks are increasingly reordering their European exposure along national lines, in terms of asset-liability matching (ALM), just in case the region splits apart. Thus, if a bank has loans to Spanish borrowers, say, it is trying to cover these with funding from Spain, rather than from Germany. Similarly, when it comes to hedging derivatives and foreign exchange deals, or measuring their risk, Italian counterparties are treated differently from Finnish counterparties, say.
And the proof that this isn’t about prejudice against national bank regulators? Look at this example:
Consider a tale I just heard from one global bank. This entity has big loans to Italian companies and public sector bodies, but a much smaller Italian funding base, creating a gap of more than €10bn. Until last year, this bank’s risk managers never worried, since this bank has plenty of deposits from elsewhere in the eurozone. Moreover, it used to raise money easily in wholesale markets. But since 2007, wholesale funding costs have surged. And while the bank could build a bigger Italian deposit base, this would be costly, since other banks are also competing for deposits. ALM fragmentation thus means the bank must either slash its loans, run a lossmaking retail bank, or be very creative.
“Global bank” means it is not an Italian bank. It is most likely a US or UK bank and thus its primary regulator is in its home country. This is about no one wants to have [fill in the name of the periphery country] assets funded by deposits that come from another country. If that country were to depart the euro, the loan would either be redenominated in the new currency, leading to an immediate loss on any currency-mismatched funding, or would default in the pretty near term (as in much of its revenues would be in the new currency, making it well nigh impossible to service the old debt). There are other possible scenarios (Germany leaving, or the surplus countries exiting en bloc) which make the safest course of action matching assets and liabilities in country.
The other disingenuous bit in the NYT extract is the harrumphing about the Spanish not ceding control over the use of the bank bailout money to Brussels bureaucrats. Um, the Spanish wanted, but did not get, a direct bailout of the banks. The money is going to a Spanish rescue fund, which means the debt is an obligation of the Spanish government (and to the extent Spain borrows from the ESM rather than the EFSF, it will be a senior obligation of the government). So given this structure, it’s completely reasonable for the Spanish government to administer the program. Moreover, that’s precisely how the Eurocrats set up the deal (as in using a Spanish entity as the rescue vehicle).
The article later complains that the Spanish won’t be bloody-minded enough and cram down small savers who hold subordinated bank bonds:
Most delicate will be whether the Spanish banks receiving the largest cash injections, like the nationalized mortgage giant Bankia, will be forced to impose losses on holders of their subordinated bonds. Those are the investors whose bonds are not backed by collateral and are thus considered more risky.
Such a “bail-in” feature is a central plank of Brussels’s banking union plan, and it is widely supported by industry experts because it would punish investors for taking undue risks. In Ireland, those types of bondholders were wiped out when Irish banks were recapitalized.
In Spain, though, the problem is that 62 percent of the holders of Bankia’s subordinated debt are Spanish individual investors, not overseas hedge funds and investment banks. It is not likely that Madrid will be willing to hit those citizens with a 65 percent loss — the loans are currently priced at about 35 cents on the dollar — at a time of 25 percent unemployment in the country.
It is too early to know whether Brussels will override Spanish political considerations and force such a write-down as a condition for lending bailout money. If it does not, doubts will continue over Europe’s ability to deliver a banking union plan with real authority.
Notice how the bondholders are treated as greedy investors, and the bail-in is presented as the only possible option. Edward Hugh’s discussion of the need to restructure the Spanish banking sector debunks both ideas:
While details of the bank rescue package and its impact on bondholders have yet to be worked out, most analysts are busy speculating that subordinated debt holders will be forced to contribute to the recapitalisation effort. But as I say any such ”bail in” would involve subordinated debt holders – and in particular holders of hybrid instruments like preference shares – taking losses. The hierarchy is just like that, you can’t haircut seniors before you have hit “juniors”. These are the banks own customers, who were basically sold the instruments on the understanding that they were “just like deposits” and very low risk. Bank of Spain inspectors warned Minister Pedro Solbes in a letter in 2006 that these very instruments were being sold to finance high risk developer loans, but no action was taken. Far from making irresponsible investors pay this measure would penalise the very people who help keep Spain’s banking system together, those small savers who forwent going for holidays on credit to Cancun, Thailand or Japan, and failed to increase their mortgages in order to buy lavish SUVs in an attempt to save for their retirement. These are the people who now face the prospect of losing their precious savings to cover the losses generated by those who did both of the above.
Hence the sort of bank “bail-in” EU regulators want, is politically impossible in Spain, especially after the Bankia scandal, and Mariano Rajoy knows this only too well. Only the Swedish path of direct nationalisation and subsequent resale is open to Spain. Unless, of course, your objective is to totally politically destabilise the country. As is evident, Spain’s developers who offered no guarantee for their lending beyond the property are now handing back the keys and assets as fast as they can, while individual mortgage holders who guaranteed the mortgage with their lifetime salary struggle to pay down mortgages which are often now worth twice the market value of the property they are associated with. If this manifest injustice is also followed up with a wipe out of small savers while large institutional bondholders walk away scot-free, well I think the next best thing to a populist revolution is what you are likely to see.
The final point worth mentioning is that both the New York Times and Hugh diss the Spanish banking regulators. But they were held up as models in the wake of the crisis, until the cajas started crumbling. I’m not saying that they did a good job, merely pointing out how fickle opinion is. But it appears the halo effect is leading the Eurocrats (and their buddies at the Times) to assume Spanish banking regulators are useless, when as the comments from Hugh indicate, their resistance to the bail-in idea is not uninformed.
As Richard Bookstaber pointed out in his book A Demon of Our Own Design, in tightly coupled systems (and our model financial system is one), efforts by individual players to reduce risk increase systemic risk. The banks went into the last crisis woefully underprepared. Ironically, the banks’ overpreparation for the possibility of a Eurocrisis is proving to be a toxic cure.