Europe’s insoluble problems
Mohamed El-Erian is calling for massive recapitalization of the banking system:
The global financial system is being refined “day in and day out,” El-Erian said, and as a result the balance between public and private is shifting and regulation is altering. “This is not being done according to some master plan,” but in reaction to a series of crisis management interventions.
None of these piecemeal policy moves restored confidence in the markets, he said. What is needed is a coordinated and simultaneous set of policy actions globally in four areas: restoration of credit markets, elimination of deteriorating assets from balance sheets, injecting capital quickly into the banking system, and regulatory forbearance.
Oh, wait, that was El-Erian back in October 2008. But he’s saying something very similar now:
In addition to specifying higher prudential capital ratios, governments must now bully banks to act immediately. Where private funding is not forthcoming, which should now be the presumption for a growing number of banks, recapitalization must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared.
The main difference, here, is the move from “regulatory forbearance” the first time around, to governments forcing “fundamental changes in the way financial institutions operate” today. But either way, this is basically, the bank-nationalization debate all over again.
In the U.S., we didn’t nationalize in 2009. We ended up taking only modest stakes in banks, and getting through the crisis through the massive application of liquidity by the Fed. If the central bank, as lender of last resort, ensures that banks will always be funded, then you don’t need nationalization. It’s a bailout by monetary rather than fiscal means, and it’s a lot friendlier to bank shareholders than nationalization is.
But the problem in Europe is that the ECB is displaying neither the willingness nor the ability to act as a lender of last resort — and in that situation, the only policy action left is for governments to step in and try to backstop the banking system directly. This is a very dangerous road to travel down: it’s basically what Ireland did when it guaranteed the liabilities of the entire Irish banking system, thereby consigning itself to a national fiscal nightmare for the foreseeable future.
So color me unconvinced that the solution to a liquidity crisis is an injection of capital. At best it’s insufficient; at worst it’s unnecessary, and only serves to exacerbate the painful process of deleveraging in a pretty drastic manner. After all, liquidity problems can hit anybody, no matter how solvent they are — just ask the German government. The Bund auction failed in large part because the European liquidity-go-round is utterly broken right now, and it’s hard to see how things would improve if Europe’s sovereigns, including Germany, started getting into the banking business.
The idea behind sovereign recapitalizations is our old friend Anstaltslast — the idea that if a bank is owned by the state, then there’s an implicit government guarantee on its liabilities. If Europe’s sovereigns started taking substantial equity stakes in their own banks, then there would be fewer worries over bank solvency: it’s almost impossible for a bank to go bust if the sovereign really doesn’t want it to. But in the context of serious worries over sovereign solvency, this tack doesn’t make a lot of sense. Once you’ve nationalized, there’s no real end to the degree to which you might end up being on the hook for the banks you now own: you can’t credibly claim that the banks you own are now so well capitalized that they’ll never need any more money. And in this case, of course, the worries over European bank solvency are worries over European sovereign solvency. You can’t tie these two rocks together, through nationalization, and expect them to float.
El-Erian is very good at explaining the problem which needs solving:
Europe must still stabilize its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.
It seems to me, though, that sequencing matters here. Liquidity is — always — more important than capital/solvency. Give an insolvent bank enough liquidity, and it can live indefinitely. Remove liquidity from a bank, and it dies immediately, no matter how solvent it might be or how high its capital ratios are. And as for asset quality, we’re pretty much talking a zero-sum game here: when the banks’ dubious assets are the sovereign’s liabilities, the real solution is inflation, not nationalization.
And as for banks’ non-sovereign assets, good luck with selling those. The shadow banking sector knows exactly what happens to asset prices when sellers put €5 trillion of those assets on the market at once, and there’s literally no one out there who would dream of buying such things at or near par.
In every crisis there’s a point of no return — if you don’t do XYZ in time, it’s too late, and the crisis is certain to get out of anybody’s control. I’m increasingly convinced we’ve already passed that point of no return in Europe. The banks won’t lend to each other, the Germans won’t do Eurobonds, and the ECB won’t act as a lender of last resort. The confidence fairy has left the continent, and she isn’t about to return. Which means, as we used to say in 2008, that things are going to get worse before they get worse.