Hugo Dixon

Does Europe need a “banking union” to shore up its struggling monetary union? And is it going to get one?

These questions are raised by the increasingly lively debate over how to break the link between troubled states in the euro zone periphery and their equally troubled banks. In some countries, such as Ireland, the lenders have made so many bad loans that they have had to be bailed out – in turn, dragging down their governments. In Greece and Italy, the banks have gorged on so many government bonds that they have been damaged by their state’s deteriorating creditworthiness. And, in Spain, the current focus of the euro crisis, a bit of both has been happening: banks made too many bad loans – and then bought too many government bonds.

One proposed solution to this incestuous relationship, advocated among others by the International Monetary Fund, involves creating a centralised Europe-wide system for regulating banks and, if necessary, closing them down and paying off their depositors. The idea is that the region’s lenders would be viewed as European banks rather than Spanish, Greek or Italian ones. If they got into trouble, they wouldn’t infect their governments; and vice versa. That would make the whole euro crisis easier to manage.

While the idea carries much theoretical appeal, such a fully-fledged banking union isn’t realistic. The incestuous embrace between governments and banks may be unhealthy, but that doesn’t mean politicians entirely dislike it. National oversight of lenders gives politicians all sorts of ways of meddling in their economies. And this is not just in the troubled countries. Relatively healthy states such as Germany and France would be loath to surrender the power to boss around banks to some supra-national authority.

Citizens in rich states wouldn’t like the idea of having to bail out banks that had gone on a binge in a completely different part of Europe either. What’s more, even if a centralised banking body was created, would it really have the clout to tell the big boys what to do?

A further difficulty concerns whether such a banking union should stretch across the euro zone or the entire European Union, which includes the United Kingdom, home to the region’s largest financial centre. Britain would argue that it shouldn’t be roped into a system that is designed to shore up the single currency it is not a part of. On the other hand, if the euro countries went ahead on their own, the single market in financial services would fragment.

Quite apart from the politics, a banking union wouldn’t actually solve all the problems. In particular, it would do nothing to stop banks owning too much government debt. Indeed, in the last few months, Spanish and Italian lenders have bought even more of this debt – using cheap money from the European Central Bank. This has helped finance their governments through a rough patch but at the cost of tying the banks’ fate even more closely to that of their countries. Over time, governments ought to be weaned off reliance on their local banks. But, realistically, this isn’t going to happen fast.

Does this mean that a European banking union is a totally dead idea? Not quite. It may be possible to cherry-pick bits of it. The most important part would be to create a Europe-wide “resolution” regime. The basic idea is that such a regime would allow insolvent banks to go bust in a controlled fashion. If shareholders haven’t put in enough capital, bondholders have to be “bailed in”. Only if bondholders also haven’t put in enough capital do deposit guarantee schemes – and possibly taxpayers – have to be activated to make sure savers are repaid. With such a framework, governments such as Ireland’s wouldn’t in future be infected by their lenders’ problems.

At present, many European countries lack such a resolution regime and those that do exist don’t collaborate effectively with one another. What’s more, until recently the European Central Bank has been hostile to the idea that bank bondholders should suffer any losses. It prevented Dublin from bailing in bondholders, fearing that this would trigger contagion.

The mood, though, is changing. The European Commission is planning to publish plans for an EU-wide resolution regime in June. Even the ECB has started lending its support to such a scheme. The devil, of course, will be in the detail. But there finally seems to be momentum behind this proposal.

A second idea that could be cherry-picked is to reinforce Europe’s deposit guarantee schemes. At the moment, every country has its own. The problem is that depositors in weak countries, especially Greece, don’t have confidence that their national schemes have enough money to pay out. So savers have been taking their cash abroad.

It is too much to expect that Germany, Europe’s paymaster, would agree to a euro-wide deposit insurance scheme. But what about some sort of reinsurance scheme? Nicolas Veron from the Bruegel think tank argues that the European Stability Mechanism, the euro zone’s soon-to-be-created bailout fund, could provide national schemes with a backstop.

Europe is not ready for banking union any more than it is ready for political union. But such ideas show there are practical ways of limiting the unhealthy nexus between lenders and their governments. Europe should grasp them.

Bailout may not be a four-letter word. But many of the rescue operations mounted to save banks and governments in the past few years have been four-letter acronyms. Think of the TARP and TALF programmes that were used to bail out the U.S. banking system after Lehman Brothers went bust. Or the European Central Bank’s LTRO, the longer-term refinancing operation. This has involved lending European banks 1 trillion euros for three years at an extraordinarily low interest rate of 1 percent.

The markets and the banks have jumped for joy in response to all this liquidity being sprayed around. So have Italy and Spain, whose borrowing costs have dropped because their banks have been able to take cheap cash from the ECB and recycle it into their governments’ bonds — making a profit on the round trip. But as has been the case with other four-letter bailouts, the LTRO has come in for criticism — most of it a variation on the theme that the way to treat debt junkies isn’t to give them another heroin injection.

One problem is that European governments could now feel less pressure to reform their labour laws and do the other painful things that are needed to get their economies fit. Another is that banks may delay actions that are required to let them stand on their own two feet: such as rebuilding their capital buffers and raising their own longer-term funds on the markets.

As if this were not bad enough, undeserving banks will be able to make bumper profits on the back of the ECB’s cheap money and, potentially, route them into fat compensation packages — although two British banks, Barclays and HSBC, have said they won’t allow bonuses to be inflated in this way. Meanwhile, the ECB could incur losses if the commercial banks that have borrowed all this money can’t pay it back and the collateral they have pledged turns out to be insufficiently valuable. Oh, and don’t forget that this is just a three-year operation. There could be another crisis when the banks need to find 1 trillion euros to repay the ECB in 2015.

The charge sheet is a long one. But the LTRO was a necessary evil. Just think back to early December when panic was stalking the euro zone. Without some form of bailout, there would have been a severe credit crunch that would have dragged the economy into a deep recession rather than the mild one it now seems likely to suffer. Large countries such as Italy and Spain could also have easily been shut out of the markets, potentially leading to a break-up of the single currency.

The ECB faced a too-big-to-fail problem. If it didn’t bail out the system, it would be faced with catastrophe; if it did, it would reward foolish behaviour. One can argue with the details. Did the money, for example, really need to be so cheap? But the central bank made a rational choice. The priority now is to limit the bad side-effects.

Mario Draghi, the ECB president, has made a start by telling European Union leaders at their summit last week that the three-year cash injection would not be repeated, according to Reuters. He said it had merely bought the euro zone time and it was essential that structural reforms were pushed through.

Hopefully, such lectures will be sufficient to do the job. But countries rarely reform unless their backs are to the wall. Take Italy. Mario Monti has made a remarkable start pushing through pension changes and liberalising services since taking over from Silvio Berlusconi. But there is much left to do: freeing up the labour market, privatising assets, revamping public spending and fighting tax evasion. How easy will he find it to push all that through now that Italy’s 10-year borrowing costs are below 5 percent?

Similar points can be made about Spain, where Mariano Rajoy’s reform programme has only just begun. Meanwhile, France, which has so far largely escaped the crisis, will not be under pressure to address its deep-seated labour market and pension problems. Francois Hollande, the socialist who will probably be the country’s next president, certainly has no ideological desire to do so.

But won’t the new European fiscal treaty deal with the issue? Sadly not. The demand for fiscal austerity was, indeed, the quid pro quo for the ECB’s bailout. But it was the wrong sort of conditionality. Balancing budgets is not the same as structural reform. The only thing pushing Europe’s governments down the latter route is exhortation and the warning that there won’t be any more bailouts.

With the banks, more tools are available to mitigate the damage from the LTRO. After all, governments, the ECB and regulators can tell lenders what to do. The most important changes – requiring them to build stronger capital bases and rely less on short-term funding — are already under way. The key thing will be to resist lobbying to delay and dilute these rules.

But there is also a case for revisiting the industry’s lax tax regime, especially if compensation remains high. Politicians have given most of their attention to taxing financial transactions, the so-called Tobin tax. But a better alternative could be to introduce what is known as a financial activities tax or FAT tax. Most countries do not apply VAT to banking. FAT, which would tax profits and compensation, would do a similar job. A three-letter tax could be part of the answer to a four-letter bailout.

There was a whiff of the lynch mob in the UK last week. Stephen Hester, the current Royal Bank of Scotland boss, was bludgeoned by politicians and the media into foregoing his bonus even though he was brought in to clean up the largely state-owned bank. Two days later his predecessor, Fred Goodwin, was stripped of his knighthood. While Goodwin bore much of the responsibility for RBS’s near-bankruptcy, removing his title flouted normal procedures. Not only is such a dressing down traditionally reserved for criminals; the prime minister, David Cameron, prejudged the verdict of the committee which reviewed the knighthood. The week was capped off by the leader of the opposition, Ed Miliband, calling for a tax on bankers’ bonuses.

While the UK is currently the epicentre of the backlash against financiers, the phenomenon is widespread across the Western world. Francois Hollande, who is likely to be France’s next president, has said that his main adversary isn’t Nicolas Sarkozy but a faceless, nameless, opponent – the world of finance. And across the Atlantic, the only serious setback in Mitt Romney’s presidential campaign so far came when he revealed that in 2010 he had paid only 13.9 percent tax on his $21.7 million of income, most of which came from his time as a private equity baron.

There is certainly something ugly about the way politicians – who themselves bear some responsibility for the economic mess – have turned bankers into a scapegoats. But the public isn’t in the mood to show sympathy to bankers these days. The issue is not so much the amounts they are paid. In the same week that the banker backlash was gathering force in the UK, Facebook announced its initial public offering. Nobody batted an eyelid at the prospect of Mark Zuckerberg, the founder, being worth over $20 billion. The difference is that people think Zuckerberg deserves his billions but the bankers don’t deserve their millions.

The belief that bankers’ compensation is unfair operates at several levels. At its most basic there is the argument that, since bankers were the ones who got the world into its current mess, they shouldn’t still be coining it. This is simplistic. The mistakes made by banks were only one factor that fuelled the crisis – and many individual bankers were innocent of the mistakes.

There is, though, a more sophisticated critique: that the whole system has been rigged in financiers’ favour, allowing them to earn more than they merit. Few people complain when entrepreneurs make millions. They are seen to have come up with brilliant ideas, taken big risks or worked extremely hard. That’s how capitalism is supposed to work. But bankers have benefited from one-way bets that make a mockery of capitalism.

The system has been skewed in bankers’ favour in two main ways. First, individual traders were paid on short-term performance. That encouraged them to spin the roulette wheel. If their bets paid off, they did well; if not, their employers picked up the tab. Second, banks in general were highly leveraged. This magnified earnings and bonus pools during the good times; but when the crisis hit, many banks were bailed out.

Over the past four years, regulators have been trying to remove these one-way bets. Much has changed in the way individual bankers are paid. A bigger slice of their bonuses is paid in equity which they cannot sell for several years, tying compensation to institutions’ long-term performance. In some cases, bonuses can be clawed back. What’s more, banks have been required to cut their leverage. This, combined with the dire economic environment, has reduced earnings and so squeezed bonus pools.

But compensation hasn’t come down as rapidly as it should have. Just look at bonuses in the City of London as measured by the Centre for Economics and Business Research. These actually rose slightly in 2007/2008 to 11.6 billion pounds after the first shocks of the crisis. Although they fell to 5.3 billion pounds after Lehman Brothers went bust, they rose again the following year to 7.3 billion pounds as the benefits of the bailout started kicking in.

For the year just ended, City bonuses are forecast to be 4.2 billion pounds. Even so, compensation is still too high. One way of seeing this is to compare how well bankers do to how well their own shareholders fare. Last year, for example, Goldman Sachs cut its pay 21 percent. But earnings applicable to shareholders tumbled 67 percent and the bank’s return on equity was a measly 3.7 percent.

The public’s concern, however, should be for taxpayers rather than shareholders. Although steps have been taken to make the system safer, the changes are far from complete. Banks are being given several years to build up fatter capital buffers so that they are better able to withstand losses. Plans to enable regulators to pack banks off to the knackers’ yard rather than bail them out when they get into trouble are still on the drawing board. Meanwhile, the industry enjoys special treatment. Just think about the 500 billion euros that the European Central Bank lent to the industry in December at a measly interest rate of 1 percent. Entrepreneurs would die to be able to borrow money at such a rate.

The sad fact is that most banks are still too big to fail. Until that changes, the system will remain rigged in bankers’ favour – and they will be vulnerable to the kind of lynching suffered by Hester and Goodwin last week.

To: Barack Obama
From: Humboldt Pye, Chairman of First Reform Bank

Dear Mr. President:

I’m writing an open letter to you and other G20 leaders on behalf of the chairmen of the world’s leading banks to say sorry.

We do not think banks are to blame for every ill the world currently faces, as the Occupy Wall Street protests and their kin in other countries suggest. A balanced audit would attribute responsibility to policymakers too: you and your predecessors set the rules of the game that we so craftily exploited. Even the public had a hand in the current mess: excess spending in some countries and inadequate taxpaying in others allowed people to consume too much.

But we are not in a position to lecture the rest of society. During the bubble years, we focused first on our own pay packages and then on profits for our shareholders. Insofar as we thought about the wider interest, we comforted ourselves with the belief that financial markets were efficient and free markets were the best way of generating wealth. So, as we pursued our self-interest, the world must by definition get better.

There were many flaws in this intellectual edifice. But contrary to popular belief, the weakness was not so much the failure of the market as the failure to apply the market. Central banks, especially the U.S. Federal Reserve, were always cutting interest rates at the first sign of trouble. The belief that Nanny was always there to rescue the markets lulled us into taking excessive risks. Second, the notion that governments would always bail out banks meant our bondholders didn’t bother to rein us in. Finally, our compensation practices amounted to “heads I win, tails you lose” bets. If our gambles paid off, we went laughing all the way to the bank. If they didn’t, the tab was ultimately left with taxpayers.

Our apology, though, can’t stop here. How we behaved after the bubble burst was arguably even worse. If it wasn’t for the extraordinary government and central bank assistance we’ve received (and still enjoy), most of us would have gone bankrupt. Despite this, we have kept paying our staff mega packages.

Our greed has enraged the people. Countries have imposed special taxes on the industry and pretty much everywhere the regulatory noose has tightened. We are not so naive to think we can swim against this tide, but we have sought to delay and dilute the most significant changes to capital and liquidity rules, which really hit our bottom line.

We have tried especially hard to wriggle out of anything that smacks of nationalization. Those of us who haven’t avoided this fate have had tough controls imposed on bonuses and dividends. The rest of us have therefore preferred to do anything to escape the state’s embrace, such shrinking our balance sheets rapidly, which allows us to boost capital “ratios” without issuing extra equity. Given the binge of the bubble years, deleveraging is appropriate. But rushing the process is probably tightening credit conditions and worsening the economic difficulties.

During this whole process, we’ve communicated terribly. Not that even a great orator like you, Mr. President, would have found this easy. The public assumes that everything we say is self-serving. But a leadership vacuum compounded this problem. Most of us were too cowardly to speak up. The few who did got pilloried – like Goldman Sachs’ Lloyd Blankfein when he made a bad taste joke about how he was doing “God’s work”.

That pretty much left JPMorgan’s Jamie Dimon to fill the void. For a while, he did a valiant job of speaking up for the industry in a down-to-earth manner. But too many flattering profiles about how he was a latter-day John Pierpoint Morgan saving the financial system may have gone to his head. His verbal assault on the Bank of Canada governor, Mark Carney, at the International Monetary Fund meeting in September shocked even other bankers.

We would now like to press the reset button in our relationship with society. At the heart of this will be the regulatory regime you are developing – in particular, measures to make sure that no bank in the future is too big to fail. Our pledge is that we will cooperate as you institute these changes, rather than fight them every step of the way.

We will also try harder to explain what we do. If we can’t show how what we do helps society, we should stop doing it.

We do not, of course, expect the public to believe our protestations of better behavior. So our senior executives are foregoing bonuses for at least two years. We are also going to squeeze cash compensation for other staff. We hope the public will in time appreciate that this leopard can change its spots.

Yours sincerely,

Humboldt Pye