The Vickers Report, published yesterday, which recommends ring fencing ordinary commercial banking from investment banking activities constitutes another example of proposals which, whatever their merit, will have no immediate impact on the financial crisis. Two reasons can be mentioned: implementing the proposals by 2019 is incompatible with the existing crisis situation and, secondly, they address a banking environment that ignores the profound transformation induced by the transference of an excess of indebtedness from the private to the public sector.
With the objective of avoiding excess rigidity, the Report suggests that banks may have a degree of flexibility in fixing the limits between deposits and loans that will be within or outside of the fence. The aim is two allow important customers (those most capable of assessing risk) to deal with the less regulated entity from whom they may expect more favourable dealing conditions in exchange of foregoing the benefits of the government safety net. This flexibility is meant to protect the competitiveness of investment banking activities.
Has it been in force, such regulation would undoubtedly have reduced considerably the amplitude of the financial crisis; it deserves therefore to be implemented. The American Dodd-Frank legislation introduces similar rules. Does it, however, provide an adequate answer to the prevention of future crisis?
The crisis finds its origin in the excessive amount of credit dispensed to the private sector (real estate, consumption), the effects of which were multiplied through opaque “financial innovations” which, in turn, accompanied by lax monetary policies, led to structural imbalances that became unsustainable. In September 2008, the need to prevent a systemic collapse of financial markets convinced governments of the need to intervene massively (and indeed very effectively) with a dual objective: rescuing the financial system by preventing the failure of banks and financial intermediaries and funding stimulus packages to support economic activity.
The restructuring of the private sector indebtedness, exemplified by the recapitalisation of banks and their steady deleveraging as well as the significant increase in private savings and repayments of consumer credit balances was achieved only at the cost of an equivalent increase in public indebtedness, leaving the global system largely as leveraged as before; the corresponding financial risks had, however, been transferred from the private to the public sector (in fine to the tax payer).
In this context, banks have played a very specific role, mainly in Europe where, traditionally, they participate much more actively in financing governments than is the case in the United States. As “sovereign debt” was considered “riskless” – both by investors (banks) and regulators - and that, additionally, banks enjoyed lucrative arbitrage opportunities between unlimited low cost Central Bank financing and returns on government securities, the balance sheets of banks grew through immoderate purchases such debt securities that were in addition exonerated from reserve requirements.
When in 2010 it became apparent that the timid economic recovery was running out of steam, despite significant stimulus packages, attention focused on the capacity of Governments to finance themselves in a context where debt servicing costs were exploding, tax revenues decreasing and government expenditures rising.
That is when markets began to differentiate between countries and particularly within the Eurozone where it became apparent that its Members were deprived from access to two traditional adjustment mechanisms: devaluation and inflation. Therefore, unless a totally credible solidarity mechanism was put in place among EMU participants, default of a Member became a distinct possibility. This realisation led to putting budgetary equilibrium back into the centre of preoccupations and to draw the conclusion that the necessary austerity needed to repair public finances was both indispensable to re-establish market confidence but incompatible – in the short term – with the aim of stimulating the economy; thus increased market volatility.
After a further 24 months of beating around the bush, Eurozone governments have still failed to put in place a permanent workable solution for dealing with the crisis, reacting always too late to events and putting forward measures which are often proven inadequate and whose modalities – despite superficial declarations on a unanimity of views – underscore profound divergences instead of a bedrock of solidarity.
It is within this context that one should analyse the deepening of the financial crisis of which the renewed fragility of the banking system is the latest manifestation. This situation is the direct consequence of the excessive exposure of banks to sovereign debts, whose “riskiness” is now at the heart of the crisis. Separating traditional banking and investment banking activities will not change this situation in the slightest because it is the financing of Governments which has now become the kernel of speculative activity.
The plea by Madame Lagarde for bank recapitalisation, particularly if it takes place through State share purchases (control?), makes sense only to the extent that an appropriate framework is adopted to regulate public sector financing exposures by these same banks. It is high time to unravel the incestuous relationship that has created an unhealthy interdependence between public finances and the banking sector.
Similarly, the declaration by President Trichet that there exists sufficient eligible and available collateral to allow the ECB to ensure the liquidity of the Eurozone banking system, can only reassure markets to the extent that the Bank is prepared to increase the size of its balance sheet without limit. Such a stance (which is credible for the US Federal Reserve) implies the unanimous support of EMU Members which is blatantly nonexistent. It also leads to the de facto “mutualisation” of member’s sovereign debt.
As is being reported evermore frequently by the media, the moment of truth is fast approaching when the irreversible and crucial choice will have to be made between building a strong integrated European Union, capable of delivering to its citizens a future both dignified full of hope and adopting nationalist introverted policies that will preside over the disintegration of 60 years of efforts, peace and prosperity.
Do we have the Statesmen capable of imposing the right choice?
Brussels, 13th September 2011
Paul N. Goldschmidt
Director, European Commission (ret.); Member of the Thomas More Institute.
Tel: +32 (02) 6475310 +33 (04) 94732015 Mob: +32 (0497) 549259