A Dilemma intimately linked to the Sovereign Debt Crisis!
The latest meeting between Chancellor Merkel and President Sarkosy seems to confirm that – at last – the leaders of the main EMU members have woken up to the urgency of the situation. They have overcome their pride and, in line with Christine Lagarde, have acknowledged that the strong appeals for action by the main world economic powers, including the United States, China and the United Kingdom are fully justified. They require the rapid implementation of measures aimed at preventing a worldwide 1930’s style depression. One can only welcome the tight schedule that the leaders have imposed in order to come up with detailed proposals concerning the recapitalisation of the banking sector.
However, the greatest difficulties still lie ahead: the measures must be sufficiently credible to restore financial markets confidence and avoid panicking depositors into a run on the banks, thus avoiding the feared systemic crisis. The official communiqué, outlining broad principles, remains limited to recognizing the need for prompt action.
Already divergences are surfacing concerning the choice of the intervention mechanisms: Germany shows its preference for each Member State assuming full responsibility for its own banks (as agreed in 2008 after the Lehman failure) while France is advocating the intermediation of the EFSF (whose mandate has been amended accordingly on July 21st) to mutualise the recapitalisation of banks and minimise the impact on the Sovereign debt statistics of the implicated countries.
The German position is far preferable for the following reasons: firstly, the EFSF will not have the required amount of funding needed, even after ratification of the July accords. New negotiations will be required whose further parliamentary ratification could prove highly problematic. Furthermore the difficult problems of setting the conditions for EFSF intervention and the exercise of ownership rights in “assisted” banks are bound to rear their ugly head. The unanimity requirement, customary in all EFSF decision making, will make the process quasi unmanageable because it implies a uniform “political” treatment in the face of a tailor-made approach that depends on each bank’s particular circumstances.
Recapitalising banks will also require funds that will not be forthcoming from purely private capital raising operations. State intervention being unavoidable, it will be imperative to protect the interests of taxpayers which seems difficult to reconcile with an intervention intermediated by the EFSF. State intervention implies therefore a strong deterioration of recovery prospects for shareholders and explains the reasons why the private sector is loath to underwrite further required capital increases.
A further reason for shunning a solution implicating the EFSF is that one should avoid at all costs the repetition of the Irish scenario in which a significant amount of the rescue package – provided in part by the EFSF – was compulsorily dedicated (€35 billion) to recapitalising its banks by the Irish State. This mechanism was tantamount to transferring to the Irish taxpayer the burden of repaying toxic loans provided by European banks, shielding the latter’s shareholders/taxpayers from the consequences of an Irish bank default. It is hard to imagine how Ireland, as an EMU Member, could agree to a recapitalisation of European banks by the EFSF without demanding the renegotiation of its own loan terms, in which case the consent of the IMF and the European Union would be required.
In addition to the “technical” modalities applying to bank recapitalisation, strong disagreements are appearing between the assessment made by authorities and the banking sector concerning the very “need” for significant reinforcement of the banks equity base. The arguments put forward supporting the adequacy of own funds, combined with the accelerated compliance with the 2019 standards imposed by Basel III agreements, have shown their ineffectiveness in the face of the collapse of Dexia which had successfully passed the 2011 stress tests (just as Irish banks had passed the 2010 tests). In the Dexia case, the fragility of the bank is attributable in part to its overexposure to the sovereign debt of EMU peripheral countries, which was not taken into account during the tests – even though the amount of the exposure was disclosed.
Applying reserve requirements based on “ratings”, which have been significantly downgraded since the start of the crisis, not only for countries having applied for assistance (Greece, Ireland, Portugal) but also for Italy and Spain and are now also threatening Belgium and France, would uncover a manifest undercapitalisation of the banking sector as a whole requiring urgent and massive recapitalisation. It should be of a size sufficient to absorb the shock of an additional write-off on Greek debt, whose default is now considered unavoidable, while also ensuring that it does not set a precedent inducing a risk of contagion. On that score, the triggering of payments insured by CDS’s on Greek debt is creating significant uncertainty, as little is known on how the “counterparty risk” is distributed or the ability of CDS writers to meet their obligations; this situation could impair the solvency of banks that believe that they are adequately protected and explains the continuing distrust among interbank participants.
A partial alternative to recapitalisation would be the deleveraging of bank balance sheets by liquidating sovereign debt holdings but in that case who would be the buyers of Government bonds? Other investors will require higher returns to compensate for the contraction of the demand induced by the withdrawal of banks simultaneously with a perception of increased credit risk expressed through rating downgrades. In a context in which Governments must simultaneously – though progressively – restore budgetary equilibrium, reduce public sector indebtedness and support their domestic banking sectors, one is facing the proverbial squaring of the circle, while any hope for salvation through economic growth appears remote.
Thus, if it is erroneous to pretend that bankers have learned nothing from the 2008 crisis, one must nevertheless conclude that the excess of risk taking, centred earlier around toxic and unregulated assets (subprime – derivatives), has been replaced by an equally dangerous addiction to public debt securities, largely encouraged by Governments, tolerated by Regulators and abetted by advantageous refinancing facilities provided by the ECB.
It is this phenomenon that I have often described in earlier papers as an unhealthy incestuous relationship between the banking and public sectors. The transformation of an over indebted private sector – that caused the 2008 crisis – into an over indebted public sector has left global excessive indebtedness largely unchanged and has only postponed the inevitable day of reckoning.
In formulating the urgent measures to be implemented, it will be necessary to answer comprehensively all questions raised here above, failing which authorities will be unable to restore market confidence. They will need to demonstrate great political courage and explain to their fellow citizens the need for significant sacrifices which, if social unrest is to be avoided, must be – and seen to be - equitable. The share of the burden to be assumed by the better off will have to be significant and accepted as a small price to pay for ensuring the long term survival of the widespread prosperity and the shared values that the European Union has presided over during the last sixty years.
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
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