July 26, 2012 9:18 pm

Sandy Weill stages an epic conversion

Marry in haste, repent at leisure – so goes the wise aphorism. There can be few better examples of this than the merger of Citibank with Travelers Group in 1998 and the demolition of the wall that separated investment from commercial banking.

Citi has long since been trading at well below its book value and the US taxpayer lives in fear of poorly regulated behemoths. Now all of a sudden Sandy Weill, chief architect of that mega-merger and a driving force behind the abolition of the Glass-Steagall act, is calling for a return to status quo ante. “We should have banks do something that’s not going to risk the taxpayer dollars – that’s not too big to fail,” Mr Weill told CNBC this week.

By the standards of conversion, Mr Weill’s change of mind must qualify as being up there with St Paul’s on the road to Damascus. That does not mean we should trust his judgment. If Mr Weill was wrong in 1999 – at fabled personal enrichment, it should be added – there is no reason to believe he is right about the matter now. And yet, Mr Weill finds himself in good and growing company. Among those who have repented at leisure are Mr Weill’s former colleagues Richard Parsons, Citi’s former
chairman, and John Reed, its former chief executive. Both were involved in the 1998 mega-merger.

All three watched Citi turn into a gigantic over-leveraged vehicle that had to be bailed out by taxpayers in 2008 (to the tune of $45bn). All three want to see a return to Glass-Steagall.

On balance they are right. In practice, the politics is against them. Having pushed furiously to consolidate disparate parts of the financial system, the Citi Three helped to create singularly effective lobbying entities.


Today’s challenge is to ensure that the much weaker Volcker rule has teeth. Alas, there is little cause for optimism. The rule, which originally sought to ban publicly-insured banks from trading on their own account, has been heavily contested by the large holding companies, such as Citi and Goldman Sachs. At 298 pages, the draft proposal was already shot through with caveats.

Paul Volcker has distanced himself from it. Earlier this year Carl Levin and Jeff Merkley, the two senators who fought hardest to strengthen the language, complained that the draft ruleseems focused on minimising its own impact”.

Since then, it has grown more complex. From reverse repurchase contracts to spot commodities, the exemptions have mounted. The final rule is expected next month. This week Sarah Bloom Raskin, a Federal Reserve governor, said she had been outvoted on the board.

Proprietary trading [is] an activity of low or no real economic value that should not be part of any banking model that has an implicit government backstop,” she said. Most of her colleagues at the Fed apparently disagree on what that means in practice.

And therein lies the problem. Like the UK’s Vickers Commission, which wants to “ringfenceretail banks from their “casinoarms, the Volcker rule was always going to be fungible. As we have seen with the recent losses at JPMorgan Chase, banks can easily pass off a gamble as a hedge. Defenders of the post-Glass Steagall world say the 2008 meltdown would have happened anyway. They may be right. The subprime crisis did not originate with universal banks. And the asset bubbles were fuelled by vast global imbalances.

However, the US has emerged from the crisis with at least 13 banks that are too big to fail. Each, including Citi, benefits from a large implicit federal subsidy that funds investment banking activities. Any one of them could bring the system down. Mr Weill may be slow on the uptake but he has a point. If a bank is too big to fail, it is too big to exist.

Copyright The Financial Times Limited 2012.

The euro

The flight from Spain

Spain can be shored up for a while; but its woes contain an alarming lesson for the entire euro zone

Jul 28th 2012

THE worst nightmares are the ones you cannot wake up from. Just ask Spain. A year ago the cost of Spanish government borrowing soared as euro contagion spread from Greece, Ireland and Portugal.

Panic seemed to subside with central-bank intervention and the promise of a new reforming government in Madrid. Since then Spain has, broadly, been as good as its word and Mariano Rajoy’s government has cut budgets, freed its labour market, played its part in countlessmake-or-breaksummits in Brussels and secured up to €100 billion ($121 billion) to prop up its banks. Yet despite all its efforts and pain, Spain cannot shake off that sense of doom. On July 25th the yield on ten-year bonds touched a euro-era record of 7.75%. Two-year bonds have climbed above 7%: investors fear that Spain must soon ask for a bail-out—or default.


Spain’s nightmare is a symptom of what is wrong with the entire euro zone. As the months drag on, the crisis is deepening. Europe’s leaders have asked the world to trust that they will do what it takes to save the euro. They have also pleaded for more time to sort out the mess. Their task is indeed immense, but as they disappear to their chateaux and beach villas, trust is draining away and time is not their friend.

The bull and the horns

Spain’s situation today is all the more shocking because only this month it had announced €65 billion of tax rises and spending cuts and won the funds for its bank rescue. This was meant to persuade investors that the whole euro zone is serious about keeping Spain. Yet the message was obliterated by news that the government now expects the recession to last into 2013 and, worse, that it will have to find the money to bail out regions which have suddenly confessed to being broke.

The prognosis for Spain is bleak (see article). The economy is in recession, the public sector is cutting spending and the private sector is reluctant to invest.

This lack of domestic demand almost guarantees that Mr Rajoy will fail to meet the target to reduce the deficit. If that happens, Spain will be asked to impose yet more austerity. That will undermine his popularity, which has already fallen steeply since he was elected. Spain’s resolve will be further damaged by rows over budget cuts between Madrid and regional politicians, who control 40% of public spending—and who, even if they are from Mr Rajoy’s party, jealously guard their autonomy. Political uncertainty will feed back into the economy, which will only deteriorate more. And the vicious circle continues.


Spain cannot escape from this trap by itself. The government has admitted it does not have money to spare, and lenders are starting to doubt its solvency. A rescue of sorts can be cobbled together, with bond yields held down by some combination of the European Central Bank (ECB) and various rescue funds (even if the main one is still subject to a German constitutional court, whose judges are scandalously slow).


But that would only buy time. Perhaps not very much. Bail out Spain and immediately investors will rightly worry about Italy and whether the rescue funds are big enough. There are technical complications: new money from the rescue funds might count as senior debt, potentially leaving other creditors worse off. And political ones: the ECB cannot sustain huge intervention if Germany, its main shareholder, objects. Saving Spain will remain a short-term fix unless the euro zone genuinely unites around a plan that is economically sufficient and politically feasible.

Unite or die


Ultimately, as we have argued, a solution requires the currency’s members to draw on their combined strength by mutualising some debt and standing behind their big banks. But alongside greater federalism, Europe also needs to do something about growth. Moderating austerity programmes is a priority (Spain shows how self-defeating they can be), but so is pursuing the structural reforms to set entrepreneurs free. Since 1975 the countries now in the euro zone have given birth to just one company currently among the world’s 500 biggest (ironically it is from Spain: Inditex); by contrast California alone has created 26. Get rid of the mad rules that keep European business puny, and it could yet surprise everyone (see article).


That blueprintgreater federalism, a bail-out and pro-growth policies—would work, but it would take time. Even if the governments could today agree on what to do, haggling over the details, holding referendums and amending constitutions could easily take three years. The delay in even starting that process is only making a difficult task harder.


The trouble is that the 17 members of the euro zone, let alone their 333m citizens, cannot agree on who must sacrifice what to allow this new Europe to emerge. Germany, which this week was warned of a possible debt downgrade, is fearful that it is already being asked to pay too much. The Dutch and the Finns are also getting cross. France differs from Germany on what changes are needed in the way the EU is run (see Charlemagne). As for the debtors, in Greece voters are drifting from the centre to the political extremes. In Italy Mario Monti is the best prime minister in decades, but he is unelected, increasingly unpopular, and ever less able to see through the reforms his country needs. Instead, Silvio Berlusconi is contemplating a comeback—and he is outshone by an (intentional) comedian, who commands a fifth of the vote in polls.

.The euro zone is stagnating (and dragging Britain down with it). The crisis is engendering a combination of public-sector austerity and private-sector uncertainty. Investors hold back because they perceive some risk of a huge loss. Consumers save for the next rainy day. For as long as the catastrophic collapse of the euro zone remains a real possibility, it is hard to see that changing.


Perhaps the politicians will be shocked into action, by a euro-zone bank run, a chaotic Greek exit, or flight from Italian government debt. But Europe’s leaders will find it increasingly hard to drag their people along with them. This is the deeper lesson of Spain’s nightmare: delay is worsening the odds of the euro surviving.

Markets Insight
July 25, 2012 12:03 pm

Europe needs a bigger crisis firewall

European leaders are attempting to get ahead of a festering financial crisis by breaking the negative feedback loop between banks and sovereigns.

Having agreed an ambitious timetable for common bank supervision in June, the European Council has formally launched a two-front war in the push towards deeper currency union. Banking union has now leapfrogged fiscal union as a priority.

Two wars require more ammunition and a solid strategy. By imparting more responsibilities without additional resources, the European Stability Mechanism, the eurozone’s permanent bailout fund, is being enfeebled. Each tap of the facility, which can lend up to €500bn against €80bn in paid-in capital, will tend to underscore how ineffectual the firewall is as a bulwark against multiple risks: sovereign default, bank runs and currency redenomination risk.

The focus on direct bank recaps also misdiagnoses the central problem: Spain, Portugal, Ireland and Greece have sky high external liabilities. Foreign private creditors are abandoning the periphery in droves. The sovereign spread becomes the price variable that adjusts higher for net capital outflows from each country, whether those outflows reflect a foreign exodus from sovereign debt or indeed the inability of the Spanish private sector to roll over maturing foreign loans.

Regardless of who provides the capital infusion, the banks’ assets will remain highly geared to the sovereign and the local economy. This affects profitability and the robustness of collateral that can be used to borrow from the European Central Bank. If good collateral is in short supply, as it is in most of the eurozone periphery, then banks will require sovereign guarantees to gain access even to a very generous lender of last resort. And then we are back to square one.

The enduring link between sovereigns and their banks underscores the Achilles’ heel of the ESM: nearly 40 per cent of the facility is guaranteed by the stressed periphery. A firewall subject to high liquidity risk and to credit rating risk makes a poor weapon for breaking the negative feedback loop.

The initial focus on direct ESM bank recaps reflects a bad strategic choice: common deposit insurance would be a much more effective and immediate tool in breaking a related link between private funding for banks and subsequent stress on sovereign borrowing costs. But common deposit insurance has been rejected because it mutualises insurance against bank runs. And thus the risk of runs against the periphery remains high.

A strategic proviso for the success of any direct ESM bank recap is agreement on a framework for injecting more capital in the event of greater losses, or alternatively on a point at which the bank should be shuttered. This raises tricky political issues in the months ahead.

First, countries must agree on a framework that allows for additional capital injections above what is initially agreed. Otherwise, markets will assume that the sovereign will still be liable for tail risk associated with banking sector losses. This creates the kind of scenario that the German constitutional court is already considering: whether Germany’s ESM liabilities are effectively unlimited.

Second, the firewall needs to be bigger. Common deposit insurance, a vital innovation to the Federal Reserve system in the Great Depression, and a common resolution fund to deal with non-viable banks are more politically palatable and practical ways to broaden the firewall than increasing the size of the unfunded ESM. Perhaps most crucially, there must be more burden sharing to reduce legacy levels of debt. Loss sharing goes to the heart of the sovereign-bank feedback loop: the price at which the ESM takes equity stakes.

Direct ESM bank recaps mitigate banking sector tail risks to sovereign parents only if the ESM is willing to provide large implicit transfers, in effect absorbing losses by taking bank stakes at inflated prices.

Broader private sector burden sharing, inclusive of senior unsecured bank creditors, should be a complement rather than an alternative. Markets have been quick to discern eurozone governments cannot credibly socialise the losses on private debt incurred by banks. The potential losses are too large. But this option is deemed too much of a risk to financial stability by Europe’s regulators.

Until there is a clear effort to tackle currency redenomination risk – the potential that some countries cannot or will not meet the tougher demands of a “reformed euro area and thus choose to return to their own currencies – the best that can be hoped from direct ESM bank recaps is they leave the blocks running to stand still. While Brussels seeks a compromise on bank supervision, banks and private investors will continue to renationalise exposures as a means to hedge against the unthinkable: a eurozone break-up.

Gene Frieda is a global strategist for Moore Europe Capital Management

Copyright The Financial Times Limited 2012.

Calming the South China Sea

Gareth Evans

26 July 2012

CANBERRAThe South China Sealong regarded, together with the Taiwan Strait and the Korean Peninsula, as one of East Asia’s three major flashpoints – is making waves again. China’s announcement of a troop deployment to the Paracel Islands follows a month in which competing territorial claimants heightened their rhetoric, China’s naval presence in disputed areas became more visible, and the Chinese divided the Association of South East Asian Nations (ASEAN), whose foreign ministers could not agree on a communiqué for the first time in 45 years.

All of this has jangled nerves – as did similar military posturing and diplomatic arm wrestling from 2009 to mid-2011. Little wonder: stretching from Singapore to Taiwan, the South China Sea is the world’s second-busiest sea-lane, with one-third of global shipping transiting through it.

More neighboring states have more claims to more parts of the South China Sea – and tend to push those claims with more strident nationalism – than is the case with any comparable body of water. And now it is seen as a major testing ground for Sino-American rivalry, with China stretching its new wings, and the United States trying to clip them enough to maintain its own regional and global primacy.

The legal and political issues associated with the competing territorial claims – and the marine and energy resources and navigation rights that go with them – are mind-bogglingly complex. Future historians may well be tempted to say of the South China Sea question what Lord Palmerston famously did of Schleswig-Holstein in the nineteenth century: “Only three people have ever understood it. One is dead, one went mad, and the third is me – and I’ve forgotten.”

The core territorial issue currently revolves around China’s stated interest ­– imprecisely demarcated on its 2009nine-dashed linemap – in almost the entire Sea. Such a claim would cover four disputed sets of land features: the Paracel Islands in the northwest, claimed by Vietnam as well; the Macclesfield Bank and Scarborough Reef in the north, also claimed by the Philippines; and the Spratly Islands in the south (variously claimed by Vietnam, the Philippines, Malaysia, and Brunei, in some cases against each other as well as against China.)

There has been a scramble by the various claimants to occupy as many of these islands – some not much more than rocks – as possible. This is partly because, under the United Nations Convention on the Law of the Sea, which all of these countries have ratified, these outcroppings’ sovereign owners can claim a full 200-mile Exclusive Economic Zone (enabling sole exploitation of fisheries and oil resources) if they can sustain an economic life of their own. Otherwise, sovereign owners can claim only 12 nautical miles of territorial waters.

What has heightened ASEAN’s concern about Beijing’s intentions is that even if China could reasonably claim sovereignty over all of the land features in the South China Sea, and all of them were habitable, the Exclusive Economic Zones that went with them would not include anything like all of the waters within the dashed-line of its 2009 map. This has provoked fears, not unfounded, that China is not prepared to act within the constraints set by the Law of the Sea Convention, and is determined to make some broader history-based claim.

A sensible way forward would begin with everyone staying calm about China’s external provocations and internal nationalist drumbeating. There does not appear to be any alarmingly maximalist, monolithic position, embraced by the entire government and Communist Party, on which China is determined to steam ahead. Rather, according to an excellent report released in April by the International Crisis Group, its activities in the South China Sea over the last three years seem to have emerged from uncoordinated initiatives by various domestic actors, including local governments, law-enforcement agencies, state-owned energy companies, and the People’s Liberation Army.

China’s ­foreign ministry understands the international-law constraints better than most, without having done anything so far to impose them. But, for all the recent PLA and other activity, when the country’s leadership transition (which has made many key central officials nervous) is completed at the end of this year, there is reason to hope that a more restrained Chinese position will be articulated.

China can and should lower the temperature by re-embracing the modest set of risk-reduction and confidence-building measures that it agreed with ASEAN in 2002 – and building upon them in a new, multilateral code of conduct. And, sooner rather than later, it needs to define precisely, and with reference to understood and accepted principles, what its claims actually are. Only then can any credence be given to its stated positionnot unattractive in principlein favor of resource-sharing arrangements for disputed territory pending final resolution of competing claims.

The US, for its part, while justified in joining the ASEAN claimants in pushing back against Chinese overreach in 2010-2011, must be careful about escalating its rhetoric. America’s militarypivot” to Asia has left Chinese sensitivities a little raw, and nationalist sentiment is more difficult to contain in a period of leadership transition. In any event, America’s stated concern about freedom of navigation in these waters has always seemed a little overdrawn.

One positive, and universally welcomed, step that the US could take would be finally to ratify the Law of the Sea Convention, whose principles must be the foundation for peaceful resource sharing – in the South China Sea as elsewhere. Demanding that others do as one says is never as productive as asking them to do as one does.

Gareth Evans, Australia’s foreign minister for eight years and President Emeritus of the International Crisis Group , is currently Chancellor of the Australian National University and co-chair of the Global Center for the Responsibility to Protect. As Foreign Minister, he was at the forefront of recasting Australia’s relationship with China, India, and Indonesia, while deepening its alliance with the US, and helped found the APEC and ASEAN security forums. He also played a leading role in bringing peace to Cambodia and negotiating the International Convention on Chemical Weapons, and is the principal framer of the United Nations’ “responsibility to protect” doctrine.

Copyright Project Syndicate - www.project-syndicate.org