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New York Times Misidentifies Main Cause of Slow Motion European Bank Run

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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.

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34 comments

  1. Bobito

    Some years ago (an expert could say how many) Spanish banks and cajas began actively promoting to their retail customes what in Spanish are knows as participaciones preferentes, and other financial instruments, as I understand it essentially preferred stocks, of the sort referred to in the post. For the most part these customers were retirees and orindary savers, with little or know financial knowledge, and they accepted the offers because they sounded good (perhaps too good). To some extent the risks of purchasing such instruments were actively concealed or obfuscated (i.e. they were presented as like a savings account, but with returns). To say it less charitably – the banks perpetrated a massive and conscious fraud. The reason that so much subordinated debt is held by ordinary retail customers is that they had no idea what they were purchasing. People should be in prison for this, and it would only compound the criminality to wipe out the savings of thousands of not very well off people.

    1. financial matters

      Spot on. It’s hard to buy a basic CD now without some sort of built in derivative product. Low interest rates are helping to fuel these sort of things but many investors weren’t interested in CDs even when they were paying 4-5% but were still looking for higher returns on higher risk products.

      This is very similar to sub prime lending where this looting is now backfiring on the looters. These products need to be much more tightly regulated so that people more clearly understand the risk to themselves and to the system as a whole. Once again taxpayers are being asked to bailout these snake oil salesmen.

    2. BondsOfSteel

      A prime example of why you need to regulate the banks sooner than later. By mis-marketing the risk to these buyers, the banks have once again made themselves too big to fail.

      Good regulation sooner would have force these securities to be sold more transparently…. and buyers would have know of the default risk.

      If you could sum of the sins of Wall Street in one phrase, it would be “the intentional mispricing of risk through opacity”.

    3. Up the Ante

      If these banks were frauding, it doesn’t matter how much money is ‘injected’ into them, they WILL do it again.

  2. Richard

    I think the problem is slightly worse than the banks lied to get retail depositors to buy high risk bank securities.

    Like the US, Spain also ran stress tests. Like the US, Spain declared its banks solvent. In fact, they talked about how well they did on the stress tests.

    Of course, any time a government is effectively recommending an investment it creates a moral obligation to bailout the investors should the investment fail.

    After all, what investor was going to say the government was wrong given that the government can see what the banks are up to while the banks are black boxes to the investor?

    1. Up the Ante

      Ringfenced so as to monopolize access.

      “After all, what investor was going to say the government was wrong given that the government can see what the banks are up to while the banks are black boxes to the investor? “

  3. JGordon

    I’m still trying to get this clear in my head, but isn’t the main reason behind interbank lending so that financial institutions can create new money via credit expansion?

    I think it’s slightly wrong to say that institutions share out deposits from high savings countries to low savings countries when deposits seem to be only an incidental, and maybe vestigal (I have seen central bankers arguing for the elimination of reserve requirements period), feature in the bank credit interchange system these days.

    1. F. Beard

      I’m still trying to get this clear in my head, but isn’t the main reason behind interbank lending so that financial institutions can create new money via credit expansion? JGordon

      That’s my understanding too (for which I am grateful to Ellen Brown). My comment at 11:13 am below was made before I read yours, btw.

      1. R Foreman

        I believe the purpose of inter-bank lending is to mitigate liquidity problems (central bank being lender of last resort). The reason inter-bank lending stopped is because all the banks suspected the other banks of being insolvent (heh, go figure).

        Houston, we have a solvency problem, not a liquidity problem.

        1. JGordon

          Interbank lending creates new money for banks to use via bank credit. In that sense I suppose it does mitigate liquidity problems, since the money created did not exist prior to the interbank loan taking place.

          1. R Foreman

            The ‘new money’ part would only be true if they made those loans using fractional-reserve lending. I’m sorry but I don’t have any information on how the bank to bank overnight loans are done, so I can’t say whether it is new money creation or just regular lending. My understanding (probably somewhat limited) was that this bank to bank lending was done strictly to prevent liquidity problems, with the central bank getting involved only in severe cases.

  4. Dave of Maryland

    So far as I can tell, the banking problem was years ago.

    It’s now a sheer currency problem, as in not enough money circulates to keep the economy going.

    Go look at TV. Restaurant ads touting 2-4-6 menu deals. Any pizza for ten bucks, provided you drive down to pick it up. People are scrounging for nickels and dimes.

    I am scrounging. I finally got my head together and in this week’s newsletter I started begging for donations and sponsors. WTF??? I run a mail order bookstore with stuff you can’t get from Amazon with an international customer base. (I ship everywhere and know how to do that. Even to mother Russia and Nigeria.) US sales have collapsed, European sales are gone, the Japanese are no longer here. Australians, Canadians and the odd Thai customer are all that are left.

    There is no money out here. Wish we were privileged like the Iraqis a few years ago, with pallets of new $100 bills, blowing in the wind . . .

    1. MRW

      Dave of Maryland, two things. (1) Your bit about the currency is wrong, and (2) what’s your website?

      About (1). It’s not “Go look at TV. Restaurant ads touting 2-4-6 menu deals. Any pizza for ten bucks, provided you drive down to pick it up. People are scrounging for nickels and dimes.”

      It’s about jobs and income. People don’t have them. But the federal government has currency. Hell. It issues it. The federal government needs to start spending to get the economy going again. I howl and rage when I hear Romney say he’s going to cut spending and create jobs. He doesn’t have a clue how the federal government works! I am now realizing that the worse training for a president is to have been the governor of a state because he brings his knowledge of state government accounting (which operates like you, me, all 50 states and every biz and household int eh country) into office with him. That’s how Alan Greenspan and Robert Rubin (early 1/1992) bamboozled Clinton with the fear that the government was running out of money and that he needed to cut spending and programs. Then this Greenspan skank had the temerity to admit last summer what he should have admitted decades ago that the federal government could never run out of money BECAUSE IT ISSUES IT.

  5. Daniel de Paris

    “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.”

    “For the most part these customers were retirees and ordinary savers, with little or know financial knowledge, and they accepted the offers because they sounded good (perhaps too good). To some extent the risks of purchasing such instruments were actively concealed or obfuscated”

    You had to be pretty old, confident and dumb (these terms appear to be synomyms in the finance world) to be a saver in Spain during late Aznar and Zapaterro adminstration.

    In view of the size of the credit-addicted economic agents in Spain vs the saving population, there is little doubt that there is very little chance for popular support here.

    Those will lose their money and more since chances that a significant number of actors behind this fraudulous credit binge be procecute and a part of the money, as limited as it may be, made back are NIL or approximatively so…

    … And that is why ideas such as the ones behind groups such as Tea party are indeed needed to counterbalance the the Krugman–and-banking-industry-friends-and-family concepts that have started to pollute a lot of left-leaning financial blogs would be welcome.

    The chances of prosecution that they arise are extremely thin indeed.

    There is not even a reasonable chance of of full blown bank nationalization with some degree of witch hunting among banking executive staff…

    A full-blown currency does not solve it. Even if some degree of monetization is of course required. But moral hazard should not be rewarded. But it will rewarded be over here. Like over the other side of the pond by the way.

  6. Abigail Caplovitz Field

    I see all this anti-national regulator propaganda as part of the larger effort to legitimize greater fiscal/political union, read, greater power for international capital and in particular, the banks, at a huge cost to democracy and individuals in the various European countries. If Europe ever wants to integrate/federalize further it should be done by treaty, not at the point of an ECB gun.

    1. financial matters

      Agree completely.

      “”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.”"

      Imagine the haughtiness of Spain wanting to run its own affairs. Interesting to watch the IMF and World Bank shock doctrine trying to be applied to western nations.

    2. Susan the other

      How exactly did Draghi get to be head of the ECB in the middle of a crisis where the US and the EU have opposing philosophies? The EU’s slow-motion national bailouts may prove to be more efficient than our slow-motion bank bailouts. Our trickle-up misery, finally reaching a clear political forum when it’s all over but the shoutin’. Trying to follow all of the EU’s funds and “mechanisms” is impossible. But it is clear they are most interested in protecting political institutions and so they are allowing them to grow real-time and doing whatever seems necessary to promote stability. In the end they will have grown their fiscal-political union from the ground up. I think they are doing a better job than we are because we have sacrificed our morality, our ethics, our good will and our trust. As far as I can tell all that is gone now.

    3. LeonovaBalletRusse

      ACF, Yeah, like the Lateran Treaty, of which the “EU Dream” is a continuation.

    4. Jim

      Emphatically agree. Unfortunately, many “progressives” believe that voters can’t be trusted to decide on matters of such consequence as maintaining national sovereignty, and that such questions must be decided upon in Brussels and imposed on the “masses”.

  7. Jackrabbit

    This is reminescent of what occurred in US banking after 2008. The Banks claimed that their lending had declined because there were no good loans to be made.

    The primary effect of this “group think” was further government support for banking.

  8. fajensen

    Another reason interbank lending dries up suddently is that when the crisis begins the finacial auditors come in, they see what is written up as assets on “our books”, and their repport can be summarised as: “Oh … Shit – We shouldn’t even lend ourselves money, nevermind lending to the competition, them being dumdums and crooks to a man, cosequently their books will be even worse than ours”!

    Nationalise zombie banks, expose the fraud, sack the imcompetent and jail the crooks will restore interbank lending.

  9. LeonovaBalletRusse

    YVES, please put the Siemens-ECB marriage within this frame. This gutsy, clarifying stand against obfuscation by the usual suspects is just one more example of your qualifications to be President 2012 by my definition.

    Imagine what you could accomplish with Roberto Unger at your side.

    Susan Webber: President 2012. There.

  10. Bam_Man

    The NY Times article is correct – in a way.
    The current crisis is the result of lack of bank supervision. The kind of supervision that would have prevented (or at least restrained) the reckless lending that occurred during the 2001-2008 timeframe which spawned deadly property bubbles in Spain, Ireland and Portugal and also enabled the explosive growth in government spending throughout the rest of the Eurozone periphery.

    1. LeonovaBalletRusse

      As the Frontline show on JPM’s “miracle” product showed, JPM’s allies in Europe worked like little metastases all over the continent for “creative” banking/looting with the insiders taking “winning” positions every which way.

  11. F. Beard

    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. WSJ

    This is a distortion. The purpose of interbank lending is to borrow back the liabilities to other banks that the lending bank creates (“loans create deposits”). That’s why interbank lending is very short term (overnight) so it can follow the newly created “credit” as it is spent through out the economy.

  12. kevinearick

    Germany is the empire node controlling the euro. It’s debt ratio is the euro debt ratio. Hence AIG and MAD is an order of magnitude greater now.

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