Echoes of 2008
Here we go again
The Europeans are pushing the global banking system to the edge
Oct 8th 2011
YOU know something bad is going to happen in a horror film when someone decides to take a late-night stroll in a forest. The equivalent in finance is a bank boss insisting that his institution is completely solid.
European bankers have been saying things are fine for weeks now, even as their exposure to indebted euro-zone countries strangles their access to funding. The amount of money parked at the European Central Bank (ECB) has risen to 15-month highs as banks hold back from lending to each other. Fears of contagion from Europe have now infected America. Banks there led the S&P500 into official bear-market territory this week, as the index briefly dipped more than 20% below a high set in April. The chief executive of one embattled institution, Morgan Stanley, sent a memo to employees reassuring them that the bank’s balance-sheet was dramatically stronger than it was in 2008, when Lehman Brothers collapsed.
Europe is not the only problem facing Western banks, of course. A long list of woes also includes anaemic economic growth, piles of new regulation and waves of litigation related to America’s housing bust. An ill-conceived congressional bill to punish China for manipulating its currency is yet another sign that America has little to be proud of in terms of economic policy. But the central reason to worry is the euro zone: a series of defaults there would unleash devastation, sparking big losses on European banks’ government-bond holdings, and in turn threatening anyone exposed to those banks.
Earlier this year, the prospect of another Lehman moment seemed remote. Thanks to the abject failure of Europe’s leaders since then, the similarities with 2008 are disturbingly real. Governments are once again having to step in to support their banks. France and Belgium this week said that they would guarantee the debts of Dexia, a lender that was bailed out three years ago but which is weighed down by lots of peripheral euro-zone debt. In another throwback, plans are afoot to create a “bad bank” for Dexia’s worst assets. The cost of buying insurance against bank defaults has surged: credit-default-swap spreads for Morgan Stanley and Goldman Sachs hit their highest levels since October 2008 this week. Rumours are rife: that banks cannot pledge collateral at central banks, that hedge funds are pulling their money from prime brokers.
Name the year
Will the fearfulness of 2011 turn into another panic like 2008? In any sensible world, it should not. Policymakers will surely not repeat the mistake they made then, of letting a big bank go under. The asset class at the heart of this phase of the financial crisis—sovereign debt—is far easier to value than the securitised subprime mortgages that caused the trouble last time. There is much greater clarity about where exposures to dodgy government bonds lie, although American banks need to become more transparent about their ties to Europe.
What’s more, the components of a solution to the immediate euro-zone crisis, long proposed by this newspaper, are fairly well understood. First, create a firewall around other euro-zone members like Italy and Spain that are solvent but need help financing their debts; second, recapitalise the European banking system, which has done far less since 2008 to fortify its defences than America’s; and third, allow Greece, self-evidently insolvent, to default in an orderly fashion.
The problem with this solution for the rest of the world is that it depends on the Europeans to carry it out. The debt crisis has been running for 18 months now, and the only way that euro-zone leaders have dazzled is through sheer incompetence. It continued this week, with some politicians admitting that a hard restructuring of Greek debt was on the table, whilst others ruled out a default. The result is the worst of all worlds: more uncertainty for banks that hold Greek debt, more pointless austerity for the battered Greek economy.
A clear plan for a forced bank recapitalisation in the euro zone is badly needed, too. The mere rumours of it happening sparked a late market rally on October 4th. There are all sorts of reasons to deplore the fact that banks would once again be propped up by public money. It would have been far better if over the past three years more had been done to boost banks’ capital and liquidity, and to create the mechanisms that would force bank losses onto creditors, not taxpayers. Every euro-zone finance minister should be forced to explain the whitewash “stress tests” that gave even Dexia a clean bill of health earlier this year. But for now the priority is to prevent a systemic meltdown, not to accelerate it for the sake of principle.
A fragmented, nation-by-nation approach to recapitalisation will not work this time, however. France and Belgium may be able to stand behind Dexia but supporting entire banking systems is beyond the capacity of many sovereigns. The European Financial Stability Facility (EFSF), the euro zone’s bail-out fund, must carry out simultaneous injections of capital into the region’s banks as soon as it can. Central banks must get into full fire-fighting mode, too. In particular, that means offers of unlimited two-year liquidity from the ECB, which was due to meet after The Economist went to press.
Above all, no amount of recapitalisation would be enough to protect banks from a cascade of euro-zone defaults. Nothing matters more than putting a firewall around the likes of Italy and Spain. Here, the news is bleak. Jean-Claude Trichet, the outgoing president of the ECB, describes this as the worst crisis Europe has faced since the second world war; but the institution he runs is unwilling to respond in kind. It is reluctant to keep buying government bonds itself, and is unimpressed by suggestions that it should boost the EFSF’s firepower by lending to it. Politicians are contorting themselves to try to strengthen the EFSF without relying on the ECB.
In 2008 governments were credible backstops for their banks and the Fed, the central bank at the heart of the crisis, was willing to do everything it could to create confidence. Now the sovereigns are the problem and the ECB’s help is limited and conditional. That is the real horror film.