The past week has shown how difficult it is to translate generic commitments into real plans. The Franco-German fight over how to give the bailout fund, the EFSF, more firepower has once again exposed the cracks in the leading Eurozone duo. But the rift is not just about how best to deal with the sovereign debt crisis, it is also about how to save banks, particularly French banks. President Sarkozy is pushing for almost unlimited financial EFSF firepower because he needs to save the French banking sector from slipping into a very dangerous zone.
Since the beginning of the crisis, bailing out Greece has also meant bailing out European financial institutions overexposed to Athens’ debt. This is a banking crisis as much as it is a sovereign debt crisis. The two are linked and feed each other. And one cannot be solved without tackling the other. In fact, the banking crisis in Europe preceded the eruption of the Greek volcano.
Ireland and Spain are the most obvious examples. There, the sovereign debt crisis is the most direct consequence of attempts by their respective governments to save their banking sectors in the wake of the Lehman collapse. In Ireland, credit default swaps, the cost for insuring Irish debt, had experienced dramatic spikes well before Greece plunged into its morass.
In essence, the inconvenient truth is that the largely homegrown problems in Greece acted as a trigger. They were certainly not the only or primary cause for the wider Eurozone crisis. Still, since the end of 2009, Greece has been the main concern of European policymakers. Blaming it all on Greece is more convenient.
By keeping Athens afloat, Germany and France were not only preventing a disorderly Greek default, they were also trying to shield their financial institutions from deeper trouble. French and German banks exposed to Greek bonds had ample time to write down their holdings of troubled debt. Two years after the beginning of the drama, at least German banks seem to have done just that. They should be able to withstand a haircut of about fifty percent on Greek bonds, perhaps even more, if that is what they are asked to do. Now that the worst seems to be over for German banks, Berlin is quite openly pushing for restructuring Athens’ debt. But while the German banks suddenly seem to be in a somewhat enviable position, the French are overexposed not only to Greece, but also to the sovereign debt of a number of peripheral countries that have come under attack more recently, including Italy and Spain. For French banks, writing down sovereign debt has become much trickier.
The Eurozone banking sector is a very crowded place. Despite the liberalization of the sector in the early and mid-nineties, financial institutions are still regulated by national authorities. Mainly for political reasons, national champions are not the exception but rather still the rule. With so many big players wrestling for profits, taking bigger and bigger risks has become much harder to resist. The French banking sector has been a champion in that regard. It is much more developed and modern than the German banking sector, where only one player, the Deutsche Bank, truly acts on a global level. Germany’s financial landscape has other weaknesses too, mainly centered around the so called Landesbanken, a myriad of hybrid financial constructions still controlled by regional governments, that have clearly outlived their original business model.
When Lehman collapsed in 2008, countries rushed to prop up their own banks, Ireland with a blanket guarantee that risked pushing the country into default, the United Kingdom (UK) with a series of nationalizations. On the continent, Germany saved the Commerzbank from the brink and kept the Landesbanken artificially alive. Across Europe, governments gave a helping hand to their banks. But there was no structural change. No Eurozone politician dared to alter the status quo, in spite of the blatant structural weaknesses of the sector and despite the magnitude of the financial crisis that started in 2007.
So far, the so-called Basel III accords have been the only real attempt to introduce more stringent international standards by substantially raising capital requirements, particularly for big banks. But some critics maintain that Basel falls well short of what the industry really needs, which is an end to the universal banking model.
In the U.S., the Dodd Frank Reform and its so-called Volcker rule has tried to establish some separation between the investment banking and more traditional commercial banking operations. In the UK, the Vickers commission proposed something similar, a ring fence around the commercial banking operations to better shield them from shocks and allow some investment banks to fail. The British government is expected to adopt those proposals. Both the U.S. and the UK are at least making an attempt at addressing the too-big-too-fail syndrome, and are trying to prevent taxpayers from being on the hook every time a new banking crisis erupts.
Nothing comparable has happened in the Eurozone. On the contrary, for years, the largely positive results of a series of stress tests have been used as proof that, overall, the European banking sector, while experiencing some temporary trouble caused by external factors, is fundamentally safe and sound.
Downplaying risks in the Eurozone banking sector has intensely irritated bankers in the U.S. For them, the Europeans are basically trying to cheat their way out of more burdensome commitments. Jamie Dimon, CEO of JP Morgan, even pronounced the bulk of the regulatory framework of the international Basel III agreement as being “un-American.” According to Dimon, Europeans were too lax when calculating their capital levels. Under Basel, banks are required to raise their capital level to 7%. If the bank is systemically relevant, those requirements are even higher. But what amounts to the highest quality capital, the so-called core tier one capital, is the object of an intense debate between the two sides of the Atlantic. The Basel rules do not help defining it. In fact, by weighing some sovereign debt as zero risk, the Basel agreement has made it very attractive for banks to heavily invest in high yielding debt, issued by Greece and other countries. If sovereign debt can be marked on the banks’ balance sheet as ‘hold to maturity,’ the current market value of that asset does not need to be taken into account, and the risk is artificially pushed down to zero. However, this exercise was clearly seen by JP Morgan’s CEO Dimon and others in the U.S. as an accounting trick.
In its latest global financial stability report, the International Monetary Fund (IMF) clearly echoed the concerns expressed by the U.S., and suggested that Europeans should better shield their financial institutions against shocks by recapitalizing them quickly. Banks should receive an infusion of about 200 billion Euros of fresh capital, the report argues. (Estimates made by some representatives of the banking industry itself suggest the number should be 250 billion Euros or more.)
This time, European politicians, including the Germans, French, and the European Commission finally accepted the rationale of this argument. The European Banking Authority, the EBA, has recently announced a new round of quick stress tests to establish how much capital is really needed.
But European banks balked. They blame sovereign debt for all their ills and ask governments to focus on the Greek drama instead of making threats aimed at the banks. If stricter capital requirements were to be imposed, they believe, it would be impossible to raise private capital in the current environment. On the other hand, they are reluctant to accept money from their governments or from the bailout fund EFSF because they do not want to become hostages of the politicians. According to the banks, the only way to meet the new capital criteria in a short time would be to sell assets and shrink the balance sheets. This could lead to a Eurozone-wide credit crunch. In essence, the banks are trying to blackmail their governments.
It is now clear that some kind of recapitalization will be imposed on banks. To measure the potential impact on the banking sector though, we still need to know how much banks will be asked to raise. But in any scenario, it is clear that banks will continue to suffer until structural changes are imposed. Some of them could be nationalized and forced to be closed down. Most importantly the Eurozone should create a truly single common financial market. This should be a common European project, one that goes hand in hand with closer fiscal integration in the Eurozone. Until that happens, the destabilizing feedback loop between banks and public debts is unlikely to be broken.
Alexander Privitera is the Washington based Special Correspondent for the German news channel N24 and is a frequent contributor to AICGS publications and events.
This essay appeared in the October 21, 2011 AICGS Advisor.