Gene Frieda: Europe’s Dying Bank Model

Yves here. Frieda makes a very important point in this Project Syndicate column, that of the role of the banking system in the European debt crisis. On one level, it may seem trivial to say that the sovereign debt crisis is the result of financial crisis. But the Eurozone leadership has not drilled into the next layer: how did this come about? The superficial explanation, that they all ate too much US subprime debt and got really sick, is superficial and shifts attention away from the real issues. European banks have huge balance sheets with a lot of low-return investments. I did some consulting work for some European banks over a decade ago (one of the remarkable things about banking is how little things change over time) and they tended to target commodity areas of banking in the US, not simply because that was where they could break in, but also because the returns were tolerable (although they did hope to move up the food chain into more lucrative business).

Frieda argues that merely having banks raise capital ratios to the 9% level stipulated in the current version of the Eurozone rescue is inadequate. Absent more aggressive measures, “no amount of capital will restore investors’ faith in eurozone banks.”

By Gene Frieda, a global strategist for Moore Europe Capital Management. Cross posted with author permission from Project Syndicate.

The good news for Europe is that it will not reenact the dramatic collapse of Lehman Brothers. The European Central Bank’s unlimited ability to provide liquidity ensures that. But European leaders have yet to recognize that old bank business models are obsolete, and that reliance on private-sector leverage for balance-sheet repair of both sovereigns and banks is doomed to failure.

Two years into the crisis, the authorities have correctly identified four crucial problems – sovereign debt, bank capital, the risk of a Greek default, and deficient growth. But they have yet to agree on cause and effect. Understanding the obsolescence of most European banks’ business models is absolutely crucial to sorting that out.

In general, the eurozone has outsized banks (assets equivalent to 325% of GDP) that are highly leveraged (the 15 largest banks’ leverage is 28.9 times their equity capital). They are also dependent on large quantities of wholesale debt – totaling €4.9 trillion (27% of total eurozone loans), with €660 billion maturing in the next two years – to fund low-yielding assets. According to Barclays Capital, the 15 largest banks increased their returns on equity by 58% between 1998 and 2007, with 90% of the gain coming from higher leverage. Returns have since collapsed.

This model’s viability depends on large amounts of cheap leverage, supported by implicit government backing. While leverage normally becomes scarce and expensive during recessions, this time declining confidence in sovereign debt also has increased the cost of capital. Government borrowing costs, which anchor banks’ own funding, normally fall during recessions. But, as “risk-free” rates have risen six-fold in the past two years, the cost of bank equity and debt has often surged to levels at which investors balk. No one should be surprised, then, that they are reluctant to recapitalize – or, indeed, lend – to eurozone banks.

Higher levels of capital are required for two main reasons. First, economic growth looks set to be much weaker than expected, meaning that capital buffers will need to be built. The European Banking Authority’s stress-test scenario from June looks more like the baseline scenario today. If traditional asset-quality considerations were the only problem buffeting eurozone banks, recapitalization would restore investor confidence, debt markets would reopen, and banks would find raising capital much cheaper than it is now. That isn’t happening, because the problem is growth.

Second, with the demise of sovereign-debt equality, eurozone banks will require higher capital-adequacy ratios to compensate for higher risk. Banks in emerging markets tend to carry higher capital buffers for a similar reason. Just as business and credit cycles there tend to be more frequent and extreme, the real possibility of de facto currency crises in the eurozone, owing to higher sovereign borrowing costs and slow adjustment to shocks under fixed exchange rates, renders massive balance sheets unsupportable and thus obsolete. Higher capital ratios are required today and, absent a credible sovereign safety net, in the future.

For example, French banks’ risk-weighted assets are €2.2 trillion, against a capital base of €167 billion – just above the 7.5% ratio established by the international Basel 2 rules. But, once risk weights are removed, assets balloon to €8.1 trillion (roughly 400% of GDP), and the equity-to-asset ratio plummets to 2%. Wholesale debt funds only 10% of these assets, but amounts to €841 billion, or 41% of French GDP.

In the event of a loss of market confidence, state guarantees for that much funding would further strain market perceptions of French creditworthiness, generating more pressure on French banks to shrink their balance sheets rapidly. And France is one of the stronger countries in the eurozone!

The latest agreement between European Union member states forces banks to raise core “Tier 1” capital levels to 9%, and will apparently require €108 billion of additional capital. But this figure is well below market expectations, as it is based on the Basel 2 rules, which have proven deficient in terms of risk weights and capital “quality” during the crisis.

With the sovereign ground quaking, reinforcing a 100-story skyscraper of leverage with an additional floor or two of concrete will not bring back wary tenants. Unless confidence in sovereign debt within the eurozone can be restored, Europe’s banking skyscrapers will need to be cut in half.

What is needed is a controlled deleveraging that recognizes that banks’ balance sheets have become too large to support, and that business models dependent on massive leverage are obsolete. Restoring confidence in eurozone sovereign debt requires not only bank recapitalization, but also a credible, publicly-funded financial safety net that is sufficient to protect the bloc’s larger states. Without that, no amount of capital will restore investors’ faith in eurozone banks.

Attempting to leverage with private money the new sovereign-debt bank known as the European Financial Stability Facility will fail for several reasons, but the simplest is that frightened private investors have already fled from European banks. After a massive private-sector boom-and-bust cycle, banks and households are deleveraging, and corporations are hoarding cash. These are the players being asked to fund the EFSF.

Once a leveraged EFSF fails, it should be clear that the eurozone will not last in its current form. The cause is excessive public and private indebtedness, coupled with the absence of an effective bailout mechanism; the effect is collapsing confidence in banks and sovereign debt.

The solution is either a broad and deep debt restructuring that imposes losses on the private sector, or an ever more expensive bailout by taxpayers. The latter would be credible only if carried out by the ECB, at the expense of its mandate. Until this choice is made, no amount of additional capital will assuage the private sectors’ fears.

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  1. readerOfTeaLeaves

    What is needed is a controlled deleveraging that recognizes that banks’ balance sheets have become too large to support, and that business models dependent on massive leverage are obsolete.

    In other words, banks have been destroying wealth. IF they had created it, there would be no need for a ‘controlled deleveraging’.
    Here’s hoping we’ve seen the end of cheap leverage.

    Looks like more stable, albeit less-profitable, banking models are in order.
    That would argue for a banking model that looks more like a utility.

    1. craazyman

      Guns don’t kill. People do. We gave you the means to elevate yourselves by giving you the cash to invest in your future and you shot yourselves. Now you cry because we gave you the means. If we hadn’t given you the means, you’d cry because we were stingy. We can’t win can we? Face it, you just hate us because we have talent. I think I need an even bigger bonus. Who can live on $10 million per year? Only somebody in the 99% and that ain’t me babe.

      -John E. Cash, Esquire [Editor’s Note: should be “Propeller Trader and gutter PhD, Bonus Baby, Looter, Blood Sucker, Vampire Squid, Zombie, Pettifogging Dialectitian and general Holistic Bozo” ]

  2. psychohistorian

    “Two years into the crisis, the authorities have correctly identified four crucial problems – sovereign debt, bank capital, the risk of a Greek default, and deficient growth.”

    I don’t buy the hypocritical argument that private banking needs to continue to be made whole.

    I also don’t buy the argument that deficient growth needs to be solved by prostrating the 99% in front of the 1% to make investment. THIS IS MADNESS!

    Gee, maybe if we ended the wars, invested in public infrastructure, education, public health, alternative energy, sustainable agriculture and environmental mitigation, we might become a better society.

    But, Excuse Me! The 99% no longer have a say in how the world is run. If we kiss someones ass maybe we can build more Fukushima’s.

    Laugh the global inherited rich into rooms at the Hague so the rest of us can get on with building a better life and world to live in.

    1. Yves Smith Post author

      You don’t understand the code in this argument.

      Making the Eurobanks shrink by 50% would give everyone in the banking sector a heart attack. And so many unemployed bankers means lower pay, which would help in making their economics make a lot more sense (as in they could retain more earnings and build up their capital levels).

      This is a radical, bank executive unfriendly argument, despite the anodyne tone. Just because it isn’t sabre rattling does not mean it is pro bank.

      1. Yearning to Learn

        I agree with your point here Yves, but I still fear that a 50% reduction in bank size will mean a 90% reduction in salaries to the tellers/worker bees, a 75% reduction in bank branches and services to customers…

        and a 50% increase in bankster CEO pay. You know the meme, improved “efficiency” and “productivity” etc.

        The execs just seem to have a lock on everything no matter what these days.

        all that said, although the ideas held within this article are correct, it seems clear that a 50% reduction (or any reduction) in banking will not be allowed until after the final collapse. again, due to financial locks on our political structure.

        1. Yves Smith Post author

          CEO pay is correlated with asset size of banks. You have a much bigger “talent pool” (yes, I hate that BS phrase) that can run a smaller bank. More competition and a smaller job equals lower pay.

          1. Nathanael

            We know from history that large, bloated corporations with CEOs looting at high rates do *not* shrink into small, lean corporations with reasonably paid CEOs.

            This just doesn’t happen. The only way to change the corporate culture is to liquidate the banks with the bad corporate culture and create new banks with a different corporate culture.

            Accordingly, we should not be talking about “deleveraging” the existing banks, but about banning the leverage levels which the existing banks *have*, liquidating them, and starting new banks which are not over-leveraged.

      2. Lidia

        Missing from so many of these discussions is the fact that “economic growth” not only isn’t forthcoming, but is actually destructive to human existence in many ways (as in psychohistorian’s reference to Fukushima, above).

        Only when “growth” is universally laughed out of the room as a benchmark for well-being will people be able to sit down and solve the real, two-pronged problem facing all of us: 1.) to start out with, a money regime based on paying interest is a logical and physical impossibility in system with finite resources; 2.) what is taken to be declining growth is—if not yet negative growth in the aggregate (with peak oil it will be perforce)—certainly negative growth per capita as the world’s population explodes, with 7 billion people demanding more than twice the energy, space and raw materials as did the 3 billion who were on the planet when I was a kid.

        Time, energy and resources spent propping up unsustainable business-as-usual banking or most other “money-making” memes are just that much less of those resources which could be used to confront the issue and modify individual and societal behaviors to mitigate the few consequences of this predicament that we might conceivably have control over.

      3. psychohistorian

        I find it infuriating that I am supposed to understand some sort of “code” about not giving the banking system a heart attack and how challenging them will improve their morals.

        Most, if not all of them work for the same global inherited rich that they rest of us do. They are just more closely connected and paid more to be sociopaths executing the social conscience of these global inherited rich.

        I don’t have the faith that you seem to have that rearranging the deck chairs is going to fix our problems, sorry.

        1. Yves Smith Post author


          You need to get up to date on who the top 0.1% are. They are not the “globally inherited rich.” They are mainly the banksters themselves (more the hedgies) and some entrepreneurs (Gates, Jobs, etc.) Like the earlier Gilded Age with its robber barons, this is mainly new money.

          And I have been the last to talk about “rearranging the deck chairs”. I am saying that cutting the banks down by 50% is as radical solution, and one that would be regarded by the current incumbents with horror. It is not “rearranging the deck chairs”, it would be a complete game changer. And by putting up the post, I’m saying I think this is a worthwhile idea.

          With all due respect, you’ve recently lost it in comments, You’ve become belligerent and have been misreading/misinterpreting posts. I’ve long been a critic and have consistently recommended very big interventions, far more aggressive than what pretty much anyone contemplates.

          You are misrepresenting my views. I don’t know what has gotten into you, but you’ve been way off base in your comments here and on other NC threads today.

          1. Fiver

            Forbes puts inherited family wealth at 30% in terms of representation on their wealth list – but note the conspicuous absence of names like Rockefeller, Ford, Morgan, Dupont, Mellon, and many others even though the corporations they founded remain both huge and immensely profitable. Frittered away? Diluted to nothing by progeny? Death taxed away? Or long since hidden from the latter in a lawyer’s maze?


            In any case, wealth does not correspond 1:1 with power. Gates is incredibly wealthy, but has little power. What really matters with the 1% (a term I dispute vigorously as it’s really at bare minimum 10% in terms of the functional elite)is whether it’s power any particular “member” is after. Look at this shot from a 1937 list of the then-most-wealthy families, and check out the placement and interlocks (corporate/political/government) of different families. Often very hands on. Do we even know who really owns what today? Who does Jamie Dimon answer to?


            1. Yves Smith Post author

              Note the Forbes list is more like the top .01%, not the top .1%.

              And I am pretty confident Jamie Dimon answers to no one. He’s stunningly arrogant and sees himself as self made. He and Sandy Weil were never part of the right clubs. Look, JP Morgan screwed over Len Blavatnik, the 80th richest guy in the world, to the tune of $100 million (my sources say even more). If JPM can blow off a client like this (he does deals all the time and the owner of a Russian oil company, they are generally feared), it shows how unconstrained JPM is (look, Dimon has bullied both Bernanke and the head of Canada’s central bank in the last two months).

              Most old money on boards are treated as placeholders. The power players are the other CEOs. Their word carries more weight with other board members. And they usually sit on the comp committee, which is the one the CEO really cares about.

          2. Nathanael

            Jamie Dimon, as CEO of JP Morgan screwed over the head of a *Russian oil company*?

            Apologies for the language, but that’s f-ing insane behavior. I expect there’s probably a contract out on Dimon’s life already. When do you think he’ll be found dead of some obscure poison?

          3. Fiver

            To say that Jamie Dimon AS HEAD of JPM acts with impunity does not make Jamie Dimon the source of his own power, does it? That JPM shoves everyone else around is hardly a surprise given its stranglehold on derivatives not to mention the Fed and Treasury. And how “dangerous” is any threat from any Russian when it’s 100% certain the US government will nail him/her in response?

            In any case, I was neither asserting that inherited wealth still runs things nor claiming banksters do not. What I was saying is that we would not necessarily know given decades of efforts to “legally” stash wealth both domestically and all over the globe and a Government committed to expanding Empire and a cloak of secrecy ever since it entered WWII – one we know lies as a matter of routine about anything of any importance. Cripes, even when the 25 years’ expires for “classified” or “secret” the most important stuff is redacted. That’s why I sent the 1937 chart. Those are the people who built it.

      4. Steve (the other Steve)

        “Making the Eurobanks shrink by 50% would give everyone in the banking sector a heart attack.”

        Or, they could just be required to raise the adequate level of capital. The trick, of course, is to define what that level is. The market will tell us what that level is when CDS of the banks go down to reasonable levels.

        Shrinking the banks in Europe by 50% would cause a huge recession. Why not just dilute the shareholders and raise capital via forced rights offerings etc?

      5. steelhead23

        I agree with you Yves, but you’ve left one shoe dangling. Mr. Frieda argues for a significant deleveraging of European banking. You have said that would give the bankers a heart attack, suggesting they might not shrink their institutions, their pay, and their prestige by half voluntarily. And of course, these same folks run the world’s central banks. Allow me to drop that other shoe. There is absolutely no reason to believe that this will end well. Indeed, these events go a long way toward destroying the “enlightened self-interest” myth. What is happening and will continue to happen is that the massive losses incurred due to excessive leverage will be transferred to individual states in a futile effort to prevent meltdown. Market confidence will remain very low. Some peripheral country will eventually default and a full-on credit catastrophe will ensue. My point, and I truly wish to be wrong, is that unenlightened self-interest will within 5 years, take the global financial system over the cliff – it is in the individual self-interests of the banksters.

        1. Yves Smith Post author

          I’ve said elsewhere that the ECB’s and Fed’s control of critical large transaction netting and payment systems (Fedwire in the US) gives them the leverage to dictate terms. Changes could be forced on the banks, but the central banks are part of the problem, not part of the solution.

          I agree the more likely result is a crisis, but this will be in less than 2 years. The ECB is not willing to blow up its balance sheet like the Fed was. So it is important to go on the record and say that there were things that could and should have been done. With two major crises in close succession, and more people in opposition (both ordinary people and the cognoscenti), the odds are better that the banksters will be cut to size.

  3. F. Beard

    The solution is either a broad and deep debt restructuring that imposes losses on the private sector, or an ever more expensive bailout by taxpayers. Gene Frieda

    Why not bailout the taxpayers?

    1) Ban any further credit creation by European banks. This would massively deflationary by itself as existing credit was paid off with no new credit to replace it.

    2) Balance the deflation in 1) with equal bailout checks to the entire population, including savers, metered to just replace existing credit as it is paid off. Continue till all private credit debt is paid off. Genuine loans of existing money could still be made.

    Who could complain? German savers would receive equal bailout checks too with non-debased Euros. The Greeks and others in the periphery could pay off their debts. The banks would be fixed.

  4. bmeisen

    ” … the 15 largest banks increased their returns on equity by 58% between 1998 and 2007, with 90% of the gain coming from higher leverage.”

    You went into this in Econned Yves but it is still difficult to understand how Euro leverage generated returns in the past but not now.

    My account: as long as sovereigns serviced their debt then the banks could generate returns by taking on more debt to purchase juicy tranches of instruments composed of PIIGS’ debt. As in the US, as soon as default appeared at the gate returns started to fall and a downward spiral across Euro began.

    1. Yves Smith Post author

      The explosion in PIIGs debt levels (and government debt levels generally) took place as a result of, and therefore after, the crisis.

  5. Robert Asher

    There is a parallel between US and European developments 1995-present. In both regions banks began to look for riskier investments (higher returns). Why? New super computers were available; deregulation; and perhaps also the declining returns from investment in manufacturing. Since the late 1970s new production and transportation technologies have diffused all over the globe, allowing low wage producers to compete with high wage producers as never before in history. I suspect that this higher level of competition lowered earnings for manufacturing companies (and some service providers), making investment in them less attractive for banks. Does anyone have data on the composition of bank loans and stock purchases by banks in the US and Europe that would shed more light on this question?

  6. psychohistorian


    When I talk about the global inherited rich I expected you and others to understand that this declination is different than the 1%. As you have commented earlier it is more like .01 or .001 percent that are the global inherited rich that I believe are the puppet masters and want them out of control of our society.

    I have been saying global inherited rich for longer than the 99/1% meme. Sorry for any confusion.

    I am sorry that you consider my comments to be off base today. I believe that I am being consistent. I am and continue to be critical of proposed solutions that do not relate structurally to the problems we have. I have no desire to give bankers heart attacks but I do want to make retail banking and international clearing public utilities rather than profit centers for the global inherited rich. I fail to understand how a tax on investment churn accomplishes or addresses the myriad of economic and social problems we have. Causing horrors in finance is not a plan to effect conscious social change.

    I don’t understand how I am misrepresenting your positions as I feel I am just saying that I don’t agree with their purported effectiveness. A Tobin tax may make sense but only within a broader context of incentive changes in finance and our overall socio-political agreement….like rule of law. It won’t make Wall Street moral on its own.

    I want structural change and not faith based bandaids. I am offending you by referring to anything that is not structural as not worthy of consideration while I may agree with the individual thig as part of a structural solution….and yes I am more strident today.

    I went to OP/OR again yesterday to talk with some folks about resources I am trying to make available to them and met some seriously damaged Iraq Veterans. Seeing them so brain injured as a TBI victim myself cut me to the bone. I was lucky enough to have more life experience, a fairly high IQ and lots of drive to help me with the progress I have made. I talk to these veterans and hear about the disservice they are being forced to endure in their lives by not getting the medical treatment they need and deserve and then be further traumatized by seeing one of their fellow soldiers being attacked in Oakland and I want STRUCTURAL change in our world.

    We deserve a better world and I will not stop trying my best to make it so.

    1. don


      I must say I’m in agreement. It cannot be argued that public discourse fails to see the extent to which we are experiencing societal and ecological collapse.

      Seeking solutions is indicative of the impotence that grips us all. What I mean by solutions is the focus on particulars, rather than the universal. Only with radical and structural change will be create a just and peaceful society that also makes room for life forms other than just our own.

      At some point we are going to have to come to grips with what this society would look like, how we organize the economy so that it is democratic, how we move away from a political system limited by formal democratic principles to one based on institutions of deliberative democracy.

      I would argue that this is democratic socialism, based foremost not on economic principles as on forms of social solidarity.

    2. Yves Smith Post author

      The changes Frieda suggests will lead to major structural change.

      What you don’t seem to get is that the financial system is like a dentonator that the big banks hold hard in one hand. if you shoot them, they relax their grip and the detonator goes off, killing them and lots of people.

      You need to disarm the bomb rather than deal with the banker holding the detonator. That IS structural change. Things I’ve advocated, like getting rid of CDS, would greatly reduce bank profits and interconnectedness. There are other concrete steps you can take (I have the better part of a chapter on this in ECONNED). And there is another crisis looming, and the Europeans (and maybe Americans too) will not tolerate more bailouts without the banks taking real pain. IO don’t like it that we’ll have to go through a second crisis to get this outcome, but the banks have stupidly set up the game so that they are bound to produce more crises. They use too many hedges that are pre-destined to fail under stress.

      But trying to blow them up only plays into their hands. You’ll get another Lehman type crisis, which resulted in the looting of taxpayers and even more power in the hands of the biggest firms.

      You need to read John Kay’s book Obliquity. In complex systems, and this IS a complex system, the most direct looking path is almost always the wrong one.

      1. don

        This is clearly a disagreement over what is meant by structural change. You put it in the context of the big banks. However, it should be obvious that by structural change one means more than change within high finance only. It goes far beyond that.

        You state:

        “What you don’t seem to get is that the financial system is like a dentonator that the big banks hold hard in one hand. if you shoot them, they relax their grip and the detonator goes off, killing them and lots of people.”

        On the contrary, who isn’t already quite aware of this? This is where your condescending view reveals itself. The deeper difficulty with your reasoning is that you assume that once the banks bombs are dismantled, add to this fiscal stimulus, then the economy can re-start with growth, at which point more substantial reforms can be obtained. Furthermore, no one here is ignoring the real damage to poor and working classes in our society that would develop as a result of finance implosion.

        I suggest that no such change would be forthcoming (and this assumes that the big banks will be dismantled, an assumption for which there is no basis), once re-growth develops; it will be simply falling back on the ‘real’ economic status quo, rather than advancing structural change here as well.

        Ultimately, this all raises two substantial issues for which you have not addressed: the role of the State (as in intervention), in which the State (as in nation state), makes a 180 degree turn in favor of the “people”. Is this really likely? Certainly your own views regarding the Obama admin. would suggest otherwise. Secondly, you remain tied to the notion of economic growth, disregarding the real global limits to growth, which is simply no longer sustainable.

      2. Nathanael

        In the mere economic sphere, structural change is easy: any government could do it. Destroy the existing megabanks, imprison their executives, found new banks to perform the useful functions the megabanks were performing. Finance the new banks with printed money. Problem solved. FDR executed exactly that solution, and it worked. Count the new government-founded banks he started — it was at least 12.

        But governments won’t do it, which shows that the problem is political. The governments have been partly bought by bankers, and partly brainwashed into believing the banksters’ lies. The banksters, of course, claim that the solution I just listed would somehow cause disaster, and they say that because it would eliminate their gravy train.

        So how do we make the structural political change? In Germany, it looks like it is happening with every Land (province) election. In Iceland, it happened with a two-fer of protests and elections. But in the UK, Ireland, and the US, the political system is so sick, so full of stooges for the CEOs, that elections aren’t changing anything. Expulsion of sellouts like Andrew Cuomo and Barack Obama from the Democratic Party? A third party? Have the states call a constitutional convention? Nonviolent revolution? Bloody revolution?

        I don’t see a clear path to make the necessary structural changes in the political system, and if they are *not* made within the next few years, bloody revolution *will* happen, guaranteed. Pharoahs who preside over famines get overthrown.

        I would like very much to avoid a bloody revolution, but at the moment most of the 0.1% and their wholly-owned political servants seem to be doing their best to make sure that that is the only possible future. It’ll be their heads, not mine, so I think they’re crazy, but by the same token, what can we do to get them to see sense?

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