MacroScope

Fed call for cap on bank size sparks fresh debate on too big to fail

Federal Reserve Board Governor Daniel Tarullo’s call for limiting bank size is sparking debate in unexpected places. Keith Hennessey, who ran the National Economic Council under President Bush, was in Chicago late last week for a discussion with Democratic lawmaker Barney Frank. The topic of the panel, sponsored by CME Group Inc., was the housing crisis.

But the most spirited exchange took place after Hennessey said that banks are simply too big to regulate adequately. “I think Tarullo has got a good point,” he said, referring to Tarullo’s argument for the need to cap bank size. Hennessey, as Bush’s economic policy assistant in 2008, was among administration officials that worked to win Congressional approval for the bailout of insurance major AIG, as its failure threatened to plunge the nation’s financial markets, already reeling from the failure of Lehman Brothers, even deeper into crisis.

Lawmakers eventually relented. On Friday, Frank, who co-authored Wall Street reform legislation designed to prevent another bailout of a too-big-to-fail financial institutions, was not about to cede ground this time to Hennessey. “I didn’t ask what Tarullo thinks – are you for breaking up the banks, and if so, to what size, and by what method?”  “Right now I don’t see any better solution than what Tarullo has suggested – yes, a size cap on banks… The alternative is a repeat of the 2008 crisis.” After the panel, Frank said he took issue with the idea, both from a technical perspective – “How do you do it? Do you sell it? Who’s going to buy it? The other banks by definition can’t.” – and because of concern that trimming bank size will hurt the ability of U.S. financial institutions to compete internationally.

Spanish rescue could cause collateral damage for Italy

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Mounting speculation that Spain is prepping for a bailout begs the question – what happens to Italy?

Sources told Reuters Spain is considering freezing pensions and speeding up a planned rise in the retirement age as it races to cut spending and meet conditions of an expected international sovereign aid package.

Markets took this to mean it was preparing the ground for eventually asking for help. According to Lyn Graham-Taylor, fixed income strategist at Rabobank:

Interview: Richmond Fed’s Lacker on Libor, ‘soggy’ growth and the limits of monetary policy

There appears to have been a significant slowdown in the second quarter. In particular we saw the pace of job creation slowed to a pace of 75,000 per month in the second quarter down from 226,000 in the first quarter and there are also concerns about slowing growth globally, beyond Europe but also in the emerging world and China, which was highlighted in the minutes (to the June meeting) this week. So, where do you think we’re headed? Are we just going to remain in a soft kind of pace? Are there upside risks to growth? Are there downside risks to growth?

Growth has definitely softened. The data are unmistakably weaker in the second quarter than we had hoped they would be. I think everyone recognized the first quarter and the end of last year were a little bit stronger than we might be able to sustain in the middle of the year but it’s definitely come in softer than I’d expected.

At the beginning of the year, it seemed as if Europe wouldn’t maybe weaken as much as we thought but lately the weakening from Europe has been coming online. In the U.S., I think we’re in a situation where we’re going to fluctuate from between the level where we are now to a level that’s more like we saw six or eight months ago. We’re going to have soggy patches, we’re going to have stronger spurts. If you look back over the last three years that’s the record you see. I don’t see a reason for that to change markedly.

Get me to the court on time

Markets were a little unnerved yesterday by concern that Germany’s top court may take a long time to rule on complaints lodged against the euro zone’s permanent bailout fund, the ESM, which was supposed to come into effect this week. Finance Minister Schaeuble urged the constitutional court to reach a speedy decision. The judges are not expected to block it but Germany’s president says he won’t sign it into law without the court’s go-ahead. A minor delay will pose no problem. A lengthier one could jolt investors.

The head of the court raised the possibility of a review taking take two to three months. That could create a dangerous vacuum though he stressed that was just one option. Schaeuble is just out again saying he hopes for a verdict before the autumn.

Bundesbank head Weidmann said even rapid ratification may not stop the crisis escalating further. With only a maximum 500 billion euros (100 billion of which is earmarked for Spain’s banks) at its disposal, the ESM looks ill-equipped to tackle the bond market head on. When the European Central Bank intervened last year to lower Italian borrowing costs it was spending 13/14 billion euros a week. And even then, it bought only temporary leeway.

Euro gang of four – or three versus one?

The euro zone’s big four meet in Rome with Germany’s Angela Merkel likely to come under pressure from Italy’s Mario Monti, Spain’s Mariano Rajoy and France’s Francois Hollande to loosen her purse strings and principles.

Monti, with Hollande’s backing, has suggested using the euro zone rescue funds to buy Spanish and Italian bonds but Berlin is not keen and there are good reasons why it might not work, not least the ESM’s preferred creditor status which means that if it piled in, private investors may flee knowing they would be paid back last in the event of a default.

The Eurogroup may have skirted the same problem with regard to the Spanish banking bailout last night by deciding to start the loans via the existing EFSF, which does not have seniority, before switching to the ESM. The EFSF’s rules will persist throughout.

No Greek relief for pain in Spain

There was no Greek relief rally (though at least we had no meltdown) and Spanish 10-year yields shot back above seven percent as a result, setting a nasty backdrop to today’s sale of up to 3 billion euros of 12- and 18-month T-bills.

Madrid has had little problem selling debt so far, particularly shorter-dated paper, but it’s beginning to look like the treasury minister’s slightly premature assessment two weeks ago that the bond market was closing to Spain is beginning to come true.
The 12-month bill was trading on Monday at around 4.9 percent. As last month’s auction it went for a touch under three percent. If that is not hairy enough, Spain will return to the market on Thursday with a sale of two-, three- and five-year bonds.

We’re still awaiting the independent audits of Spain’s banks which will give a guide as to how much of the 100 billion euros bailout offered by the euro zone they need. Treasury Minister Montoro was out again yesterday, pleading for the ECB to step in – presumably by reviving its bond-buying programme – something it remains reluctant to do, although a strong sense of purpose and commitment on economic union at the EU summit in a fortnight could embolden the central bank to act.

Battening down the hatches

There’s a high degree of battening down the hatches going on before the Greek election by policymakers and market in case a hurricane results.

G20 sources told us last night that the major central banks would be prepared to take coordinated action to stabilize markets if necessary –- which I guess is always the case –  the Bank of England said it would  flood Britain’s banks with more than 100 billion pounds to try and get them to lend into the real economy and we broke news that the euro zone finance ministers will hold a conference call on Sunday evening to discuss the election results – all this as the world’s leaders gather in Mexico for a G20 summit starting on Monday.
Bank of England Governor Mervyn King said the euro zone malaise was creating a broader crisis of confidence.

The central banks acted in concert after the collapse of Lehmans in 2008, pumping vast amounts of liquidity into the world economy and slashing interest rates. There is much less scope on the latter now. The biggest onus may fall on the European Central Bank which may have to act to prop up Greek banks and maybe banks in other “periphery” countries too although the structures to do so through the Greek central bank are in place and functioning daily. In extremis, we can expect Japan and Switzerland to act to keep a cap on their currencies too. As a euro zone official said last night, a bank run might not even be that visible and start on Sunday night over the internet rather than with queues of people outside their local bank on Monday morning.

Spain calls for bank aid

Things are on the move in Spain although nothing is set in stone yet.
Treasury minister Montoro’s call yesterday for “European mechanisms” to be involved in the recapitalization of Spain’s debt-laden banks – a reversal of Madrid’s previous insistence that it could sort its banks alone – unleashed a barrage of whispers in Europe’s corridors of powers.

Our sources say that the independent of audit of Spanish banks’ capital needs, the first phase of which is due by the end of the month, will be a key moment after which things could move quickly.

The hitch is that Madrid still doesn’t want the humiliation of asking for a bailout and Germany will not countenance the bloc’s rescue funds lending to banks direct. One possible solution floated last night –  the EFSF or ESM bailout funds could lend to Spain’s FROB bank rescue fund, which could be viewed as tantamount to lending to the state but would give the government some political cover to say it wasn’t asking for the money. This is anything but a done deal and there would still be some strings attached which could be tough for Prime Mininster Mariano Rajoy to swallow.

Merkel under pressure … but unbending

Some interesting events to  ponder over the weekend, though not many of them came from the G8 summit which, as is customary, was strong on rhetoric but bare of any specific policy measures to tackle the euro zone crisis. However, markets seems to have tired of their panicky last few sessions. German Bund futures have opened lower as investors took profits rather than seizing on any positive news. European stocks have edged up.

It does appear that with the ascension of France’s Francois Hollande, the G8 firmament turned into G7 (or maybe 5 since we didn’t hear much from Japan and Russia) versus 1 (Germany) but as things stand we’re still heading for a fairly anaemic “growth strategy” unless euro zone leaders coalesce behind the notion of giving Spain and Greece longer to make the cuts demanded of them. Spain has moved the goalposts further in the wrong direction, revising its 2011 deficit up to 8.9 percent from 8.5 and blaming the overspending regions. That means its already loosened target of 5.3 percent for this year is now even harder to achieve.

Hollande is talking up the case for common euro zone bonds but that will not wash with Berlin for a long time yet. Sources said Monti used the G8 forum to promote a pan-European bank deposit guarantee fund. Good idea but that too will only be conceivable if the European financial sector is on the point of toppling. And who will underwrite it? There is talk too of allowing the EFSF to lend direct to banks to ease the Spanish government’s reluctance to ask for help. That may have a slightly better chance of success but Berlin doesn’t like this idea either.
Look no further than the German Chancellor’s take on the summit – it was all a great success, she said. Everyone agreed that we need both growth and fiscal consolidation.

Fed’s Tarullo not making any promises

We’re pretty sure that Daniel Tarullo, the Federal Reserve’s point person on regulation, expects the United States will finally understand exactly what financial reforms are coming “some time next year.” But the Fed governor made doubly sure to qualify that statement lest anyone – especially any press “in the back” – take it as gospel.

At a conference in New York Wednesday morning, Tarullo was asked how long it would take for the various regulatory agencies to give final details on the raft of financial crisis-inspired reforms, everything from Basel III capital standards to the Volcker ban on proprietary trading. Here’s what he said:

“I know it’s frustrating for people not to have the proposed rules out. On the other hand, doing them simultaneously does allow us to see whether something in one of the proposed capital rules will affect something in another proposed capital rule, so that we end up, when we publish the final rules, with fewer anomalies, questions and the like, which will undermine the ability of a firm or academic or just anyone in the public to see and understand how these things are going to function. I hesitate to give a time line on exactly when we’ll get there. But I think…it seems to be reasonable to expect that some time next year the basic outlines – and I don’t just mean the ideas, I mean the details associated with the major reform elements – should be reasonably clear to people even though questions will inevitably rise in implementation. (You) don’t want to take that as a promise. But as I think about these various streams, that is my expectation… To have gotten it done this year would have meant the sheer magnitude of the task would have lead to a lot of inconsistencies or open questions, which then would have just produced another round of change. So you’ve got me on the record saying some time next year, but I tried to qualify it as much as possible – that’s for all you people in the back…”