November 14, 2011 2:08 pm
Sever the death spiral link of banks and governments
The financial fate of Europe’s banks and its governments are inextricably linked: because the banks are the primary source of funding for government deficits, government debt represents a large proportion of the asset base of most eurozone banks. Insolvency of one therefore threatens insolvency of the other.
The prevailing narrative is that this symbiosis makes the largest European banks too big to fail, driving eurozone governments to provide massive capital infusions and guarantees to banks during financial crises. The truth, however, is that, given the level of eurozone government indebtedness and the relative size of Europe’s banks, Europe’s largest banks are now too big to save.
The now inevitable restructuring of eurozone government debt will result in bank capital deficiencies which the International Monetary Fund estimates could exceed €300bn. European taxpayers cannot afford to cover this bill: tapping already thin public coffers will mean higher sovereign borrowing costs and dimmer prospects for growth. Even the strongest European economies now face this constraint.
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Ultimately European governments will have to abandon their implicit guarantees for banks to protect their own solvency.
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Equally, in the short term, governments cannot walk away from support for the banking sector without putting their own immediate funding needs at risk and potentially triggering the collapse of private credit formation in the eurozone with disastrous effects on the real economy.
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These are the unfortunate facts: a number of governments will need to restructure their debts to bring them to a sustainable level; as a result, banks are going to need significant capital to absorb those losses; and, given the high level of government indebtedness across the eurozone as a whole, new sources of private funding needs to be found to cover those losses to get out of the death spiral of interdependency that eurozone governments and banks now find themselves in.
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First, there needs to be an honest sizing of the problem, identifying those sovereigns whose current debt levels are hopelessly unsustainable as well as the level of debt relief required to restore sustainability.
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Second, the European Banking Authority (EBA) must implement stress tests that take into account the identified need for write-downs of sovereign debt and the consequent bank capital that needs to be raised.
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Third, the EBA should provide a deadline for affected firms to make up shortfalls from private markets or out of retained earnings.
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Fourth, a federal financing body, such as the European Investment Bank (EIB), must provide a capital backstop should identified shortfalls fail to be met from private sources. To give it the firepower it needs for the size of the problem, the EIB must be empowered to raise debt supported by a stream of new tax revenues dedicated to retire the debt incurred.
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Fifth, because the death spiral of interdependency makes further tapping of general tax revenues counterproductive, and collective credit support – such as through a leveraged European Financial Stability Facility, the eurozone’s bail-out fund – is constrained by the over-indebtedness of the member nations, the EIB’s capital backstop should be funded through a new federal tax on bank salaries and profits above defined levels.
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Neutralising the long-term threat to financial stability of too big to save banks, however, will require a separate antidote. Using France as an example, assets at its five largest banks are over three times the size of the French economy. The disorderly failure of any one of them could cripple credit markets, not just in France, but throughout the eurozone. Yet France can no longer afford to save any one of them on its own.
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Therefore, policymakers need to take a play from the antitrust handbook and break up any firm that is too big to save, thus removing a common threat to fiscal accounts and financial stability.
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The one inescapable conclusion we must all draw from the recent financial crisis is that the so-called “global systemically important financial institutions” are not only too big to fail and too big to save, but most importantly, they are also too big to manage. The risks they run are too complex for the small group of managers at the top of any one of these mammoth organisations to fully grasp, for regulators to supervise and for investors to understand and discipline.
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In the US, the Dodd-Frank act provides regulators with the authority to break up banks with more than $50bn in total consolidated assets that pose a threat to financial stability. Europe needs comparable authority. And regulators on both sides of the Atlantic must have the courage to exercise it.
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Jim Millstein is chairman of Millstein & Co. He most recently served as chief restructuring officer at the US Treasury, where he led the rescue of AIG. Millstein was previously global co-head of restructuring at Lazard
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Copyright The Financial Times Limited 2011.
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