Europe chokes moral hazard: James Saft
March 25 (Reuters) – Moral hazard may not be quite dead in
Europe but it has a bad, hacking cough.
A new, tougher policy on banking bailouts, made flesh in
Cyprus and enunciated by Dutch Finance Minister Jeroen
Dijsselbloem, will shrink Europe’s arguably overly-large banking
system and, ultimately, may put unbearable pressure on the
Actually the policy, allowing holders of bonds and uninsured
depositors in insolvent banks to actually lose money, is not so
much new as a return to following the rules of capital
structure, with equities taking the first loss and uninsured
deposits the last to suffer.
It does mark a huge change from how Europe, and the U.S.,
have handled bad banks since the crisis began, sheltering
creditors and depositors from the consequences of their
risk-taking in ways that make them likely to take on more and
sillier risks, a syndrome called moral hazard.
“If there is a risk in a bank, our first question should be
‘Okay, what are you in the bank going to do about that? What can
you do to recapitalise yourself?’,” Dijsselbloem, who also heads
the Eurogroup of euro zone finance ministers, told Reuters and
the Financial Times.
“If the bank can’t do it, then we’ll talk to the
shareholders and the bondholders, we’ll ask them to contribute
in recapitalising the bank, and if necessary the uninsured
deposit holders,” he said.
“It will force all financial institutions, as well as
investors, to think about the risks they are taking on because
they will now have to realize that it may also hurt them. The
risks might come towards them.”
After a first, and disastrous, plan which would have
violated the spirit of an EU policy of insuring accounts of less
than 100,000 euros, Cyprus, the EU and IMF eventually agreed a
banking bailout which shielded small accounts and concentrated
pain not only on those larger than the limit, but on depositors
in the weakest banks.
Even more significant was the decision to force senior
bondholders to accept losses. Both moves will give pause to
investors who provide money to banks in Europe, who will likely
now either decide this is not worth the risk, or who will demand
better compensation for the hazards which now fall on them.
This is an excellent policy but one which is going to hurt a
great deal. It is not simply that this partly undoes the policy
of public insurance against private risks which generate private
gain. It also acknowledges, tacitly, that the debts within the
euro zone may be too large, that losses must be suffered to
allow restructuring to happen on better foundations.
SHAME ABOUT THE COSTS
That’s not to say this is a policy change without costs. The
first fear is that it will spark a bank run, with large
depositors fleeing banks in weaker economies like Spain or
Italy, or in ones like Luxembourg in which the banking system
dwarfs the rest of the economy.
This is certainly possible, and corporations, which have a
legal duty to act in their shareholder’s best interests, will
likely leave the weakest banks in the most doubtful countries,
if they have not already. That said, we saw little early signs
of distress in financial markets. The Swiss franc rose against
the euro, a sign of money flowing to safety, but not
dramatically, and financial indicators didn’t seem to show huge
pressure on banks on the periphery of the euro zone.
What will happen, almost certainly, is that the cost of
raising capital will go up for banks, with the weakest penalized
the most. That is going to cause Europe’s banking industry to
shrink, hopefully slowly and over many years. While this is not
going to be pleasant for those closely involved, the alternative
is worse – keeping banks on a kind of reverse welfare in which
the poor subsidize the rich in making bad decisions.
As banking shrinks a large problem is going to be the
availability of loans from banks, and their cost. Europe is, in
contrast to the U.S., heavily reliant on bank lending and with
less well developed capital markets in which to sell bonds. With
the continent already suffering from tough credit conditions,
this is only going to increase the near term economic hit.
This is also going to increase pressure for a controlled
breakup of the euro, and may make it inevitable. Cyprus, like
Greece, is going to suffer a massive implosion of its economy
without being able to devalue its currency. That may well prove
Those two realizations; that investors need to look out for
themselves and that the euro’s center may not hold, are as big
as they are scary.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at email@example.com and find more columns at blogs.reuters.com/james-saft)