11/23/2012 05:20 PM

Inevitability of Debt

The Faustian Bargain between States and Banks

By Stefan Kaiser


States and banks have made a deal with the devil. Banks buy the sovereign bonds needed to prop states up in the tacit understanding that the states will bail them out in a pinch. But experts warn that this symbiotic arrangement might be putting the entire financial system at risk.

When he presented his proposals for taming banks in late September, Peer Steinbrück was once again spoiling for a fight. The Social Democratic candidate for the Chancellery in next year's general election railed against the chase for short-term returns and excesses within the sector and harshly criticized the "market-conforming democracy" in which politics and people's lives had become mere playthings of the financial markets.

Steinbrück's speech lasted half an hour, or a minute for each of the pages of a document he had prepared on the same issue. The paper lists a whole series of suggested regulations, most of which seem entirely sensible. Most interesting, however, is what's missing from the paper -- and what has thus far been absent from almost all of the proposals of other financial reformers: the disastrous degree to which countries are now dependent on banks.

As European countries have dug themselves deeper and deeper into debt in recent years, there has been a dramatic increase in this dependence. Governments are addicted to borrowed money -- and banks meet this need by purchasing sovereign bonds. As an unspoken reward, the banks expect nothing less than a guarantee of their own survival. Should a bank run the risk of collapse, the state is expected to use taxpayer money to prop it up.

Brimming with Bonds

This government-bank bargain is somewhat of a Faustian pact: States need the help of credit institutions if they want to take on more debt. But, in doing so, they place their fate in the hands of the financial markets. Indeed, the European Central Bank (ECB) estimates that European banks now hold some €1.6 trillion ($2.1 trillion) in sovereign bonds.

What's happening in Greece right now provides a dramatic example of how a state can make itself dependent on banks. The country is de facto insolvent and can no longer secure any loans on the financial markets. Nevertheless, it continues to be able to secure fresh funds by issuing short-term bonds, primarily to Greek banks, as it has recently to make up for a lack of liquidity as euro-zone member states continue to delay the release of the next tranche of emergency aid. Greek banks, for their part, finance their ailing country not only because the bonds have high yields, but also because they can deposit the bonds as collateral at Greece's central bank in return for fresh cash infusions of their own.

The books of many Spanish and Italian banks are also brimming with sovereign bonds issued by their home countries. They have taken out huge amounts of cheap loans at the ECB and reinvested most of the money in sovereign bonds. The business logic behind this strategy is clear: While the ECB only charges 1 percent interest on its loans, the sovereign bonds have yields of up to 6 percent.

Privileges and Denial

Such returns make great sense for the banks in the short term but present a massive problem in the medium term as they enter more and more risky assets into their ledgers. "It's important for the institutes to diversify their assets," says Hans-Peter Burghof, professor of banking at the University of Hohenheim, in southwestern Germany. Burghof also believes that their massive holdings in sovereign bonds are putting the entire financial sector at risk. "If one wants a stable banking system," he concludes, "one cannot abuse it as a vehicle for state financing."

But that's exactly what governments and oversight agencies in Europe are doing. Whenever they formulate new regulations for the banking industry, they always steer clear of dealing with banks' privilege of financing states. Take the following examples:

  • Capital resources: Plans call for introducing new equity capital regulations for banks in 2013. The rules oblige banks to gradually increase the amount of their own capital backing risky investments and loans. What is counted as risky? Pretty much everything -- except sovereign bonds. As before, these will not have to be backed by any equity capital at all. Given recent events -- such as last spring when banks were forced to write down billions in losses involving Greek sovereign bonds -- the exception is notable.

  • Liquidity: The new regulations stipulate that banks keep enough liquid assets on hand to be able to survive for 30 days without receiving fresh funding from capital markets. Liquid assets is a category that also includes sovereign bonds, giving banks yet another reason to stock up on these sometimes risky securities.

  • Financial transaction tax: Last summer, after efforts to come up with a Europe-wide solution failed, France pressed ahead by introducing its own tax on financial transactions. The law levies a tax at a rate of a set percentage for each trade of the shares of French companies as well as of certain derivatives. But the French law does not apply to trades involving -- you guessed it -- bonds issued by countries and companies.

Many experts look sceptically on the degree of preferential treatment governments give to such bonds. Early this week, even Jens Weidmann, the president of the Bundesbank, Germany's central bank, spoke up and called for a radical change of course. Banks must be more strictly prevented from "exposing themselves to solvency risks of states," he said. He also proposed a solution in the form of a kind of upper limit on sovereign-bond purchases similar to the regulations limiting how much a bank can lend a company. In the latter case, banks must keep 100 percent in equity capital on hand to back major loans above a certain amount. The high costs of doing so lead most banks to limit the amount they will lend individual companies.

What's more, Weidmann argued for requiring banks for the first time to back the sovereign bonds on their ledgers with equity capital. This call echoes the demand of many business experts. "During the crisis, we learned that sovereign bonds are no longer risk-free assets," says Martin Faust, professor of banking management at the Frankfurt School of Finance & Management. "For this reason, it would only make sense to call for backing with equity capital."

A Cozy Symbiosis

However, it is unlikely that these suggestions will ever be realized. "That is a political problem," Faust says. "Doing so would be acknowledging that states can go bankrupt."

Implementing Weidmann's proposals could indeed cause serious problems for countries like Spain and Italy. Interest rates on those bonds are already high due to the perceived risks associated with owning them. Implementing capital requirements for sovereign bond purchases would make them even less attractive, which would then drive interest rates even higher. And that could further exacerbate the euro crisis.

It is a situation which suggests that policymakers should act with caution, but does not justify the complete lack of action. Still, the benefits of doing nothing are clear. It allows states to continue piling up debt.

Click on charts to enlarge


November 22, 2012, 5:17 p.m. ET

Hello, Europe

On its current trajectory, America will look like France or Greece before long.


The election is behind us, with President Obama's strong victory over Mitt Romney. Mr. Obama did not do as well this time, winning by 3.3 million votes compared with 9.5 million in 2008. But he overcame a weak economy and some unpopular policies to win a second term, and that is no small feat.

Still, one could argue his greatest challenge is in front of him, because America's economy continues to do very poorly. Employment levels are still 3% lower than before the recession that began almost five years ago, meaning our so-called recovery of the last few years is far below other recoveries dating back through the 1950s.

People of all income levels feel the impact of economic weakness. The number of people receiving food stamps has increased by 15 million, or almost 50%, in the past four years. The number of taxpayers earning $1 million or more per year was just below 400,000 in 2007 (having risen quite a bit from 170,000 in 2002), but it has plummeted and was only around 268,000 in 2010.

Things may get worse before they get better. Just a few days ago, the Congressional Budget Office predicted that the "fiscal cliff" we face in January, if the president and Congress don't do something very soon, would push us back into recession and raise the unemployment rate above 9% by the end of next year.

There is much to be done in Washington. The White House and Congress must look beyond the immediate fiscal cliff and focus on economic growth for the longer term. One place to start is with corporate tax rates, an area where Mr. Obama has indicated shown some willingness to compromise with House Republicans. The U.S. has the highest corporate tax rate in the developed world, around 14 percentage points above the average rate among major advanced economies. This is a limiting factor in job creation. In addition to tax reform, there must be spending control and some reduction in the massive levels of regulation we have seen in the last few years.

Unfortunately, what we may see over the next four years is the opposite, the continuing Europeanization of America, putting the government in charge of all that we do—from stricter management of the economy and family and health decisions, to higher taxes and higher government spending. If nothing is done soon, the higher taxes will take effect in weeks. First, the end of the Bush tax cuts comes on Jan. 1, resulting in higher taxes on almost everyone. Second, because of ObamaCare, taxpayers making more than $200,000 ($250,000 for married couples) will pay an additional 3.8% on investment income, not a good move for job creation. And we see no inclination on the part of the White House to reduce federal spending or lessen the regulatory burden on our nation; in fact, we see just the opposite.


What happened in the recent election? Certainly some of the results were as expected. White men voted for Mr. Romney 62% to 35%, and white women voted 56% to 42%. Blacks suppported Mr. Obama 93% to 6%, and Latinos 71% to 27%. Voters earning less than $50,000 a year voted for Mr. Obama 60% to 38% while those with higher incomes voted for Romney 53% to 45%.

Democrats voted for Obama 92% to 7% and Republicans for Romney 93% to 6%. Mr. Romney, unlike John McCain, won with independents. But that was not enough to win in 2012 because the Democrats did a better job getting their vote out.

State ballot issues can also tell us a good bit about our nation. In California, Gov. Jerry Brown's Prop 30, a $6 billion tax increase, won with 54% of the vote. In Florida, voters rejected a ballot item that would have limited spending increases to the rates of inflation plus population growth. Both were victories for public-sector unions and others who favor larger state government.

For the first time, advocates for same-sex marriage won at the ballot box. Maryland, Maine and Washington state all legalized it by referendum or initiative, and Minnesota voters rejected an amendment that would have written the traditional definition of marriage into the state constitution.

That brings the number of states where gay couples can marry to nine. And, there was a big pot vote in some states. Measures allowing recreational pot use passed in Colorado and Washington state but failed in Oregon.


Looking back on America's experience after World War II, the results of the recent election, and the challenges faced in Washington, it is obvious our country has become more liberal. Yes, we had Ronald Reagan, but we also had Franklin D. Roosevelt, Lyndon B. Johnson and Jimmy Carter. And now, we have Mr. Obama, the most liberal of them all, elected to a second term. The truth is that the American ship is headed across the ocean toward Europe, aiming to become more like France, Italy and Greece.

Those who worry about the Europeanization of America, and the related economic and social decline are right to be unsettled. Republicans and conservatives must spend some time learning lessons from the election and then do all they can to slow the ship, stop it, and change its course, or soon enough we will look like those countries do today.

Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

November 22, 2012 5:39 pm

Beware the next financial blindspot

During the crazy credit boom of 2006 and 2007, Paul Tucker, now deputy governor of the Bank of England, tried to sound an alarm about shadow banks.

In a couple of prescient speeches he warned that “Russian doll finance” or “vehicular finance” – as he dubbed the shadowy network of non-bank finance entities in London – could pose systemic risks.

In the event, his comments had little impact; few listeners had a clue what “Russian doll financemeant. But this week Mr Tucker finally got his wish: the Financial Stability Board issued a report that called for more oversight of the shadow banking world and its $67tn assets.

In some senses this is encouraging. But as the FSB finallybelatedlyflexes its muscles, it is worth asking why it has taken six years for regulators to act.

For behind that “Russian dolltale there is a powerful principle that sheds light on past policy mistakes and highlights remaining challenges.

The problem is one of tunnel vision, or what might be described as “silos” in policy making.
Several decades ago, when people such as Mr Tucker started their careers, institutions such as the BoE had a generalist creed: employees moved between departments, graduates were hired from a range of disciplines and senior BoE officials were expected to watch for trouble by using instinct and peripheral vision as much as models.

But when the BoE gained independence in 1997, PhD-wielding economists became more dominant and specialist macroeconomic and monetary policy analysis turned into mental silos, separated from the grubby weeds of finance or markets.

That was partly because the Financial Services Authority assumed responsibility for bank supervision. But another factor was that economists such as Sir Mervyn King, current BoE governor, had little desire to peer into the entrails of finance.

Collateralised debt obligations or structured investment vehicles did not seem connected to the “realeconomy or even monetary policy; at least not in the eyes of high-status economists.

Some regulators on both sides of the Atlantic tried to bridge that mental gulf. When Mr Tucker, for example, became head of markets at the BoE a decade ago, he realised the operations of CDOs and SIVs were affecting the flow of credit. He even suggested an analysis of “vehicular finance” should be incorporated into discussions of monetary aggregates, such as M4.

But he faced at least two big obstacles in raising interest.

First, it was unclear who was responsible for analysing, let alone policing, this non-bank world. For while the FSA was watching the micro-level operations of banks, and the BoE was monitoring macro financial stability, CDOs and SIVs fell between the cracks.

Second – and more subtly – the silo mentality was so entrenched that Mr Tucker did not even have the words to communicate his fears. He knew the phrasenon-bank finance” sounded boring, so he tried to come up with alternatives. But they failed to grab attention.

Indeed, it was not until Paul McCulley, a senior Pimco official, coined the phraseshadow banking at a Jackson Hole economics conference in August 2007 that a term caught on – and policy makers finally had a way to discuss vehicles such as CDOs and SIVs. Providing a catchy label, in other words, helped shift the policy debate.

Ironically, many financiers now grumble that the phraseshadow banks” has become too catchy. Some policy makers agree: in some languages the term sounds excessively negative and it has come to be used in an unhelpfully broad sense. As a result, a drive is afoot to find new labels.

But, if nothing else, this twist in the debate shows that some officials have grasped the point: words (or a lack of them) can set policy priorities. Other lessons have been learnt, too.

These days, for example, the BoE’s new Financial Policy Committee is trying to take a holistic view of the financial system. Senior officials such as Andy Haldane are doing pioneering, silo-busting research that blends economic and financial analysis with other fields, such as zoology.

And Mr Tucker himself recently gave a thoughtful speech to economists in Oxford, calling for more silo-busting measures.

But while this is laudable, the sad fact remains that the problem of silos – and mental blind spots – has not gone away; on the contrary, it is intrinsic to any large, complex system.

So the question investors should now address is what other issues continue to fall through the cracks. What about cyber security, pensions or financial infrastructure?

Or is there something else we are ignoring because it is outside our mental map? Ideas would be gratefully received or, better still, sent to the FPC (or its US and eurozone counterparts), preferably with a catchy label that is as powerful as “shadow banks”.

Copyright The Financial Times Limited 2012.