The European Banking Disunion

Daniel Gros

06 November 2013

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BRUSSELSThe purpose of the euro was to create fully integrated financial markets; but, since the start of the global financial crisis in 2008, markets have been renationalizing. So the future of the eurozone depends crucially on whether that trend continues or Europe’s financial markets become fully integrated. But either outcome would be preferable to something in betweenneither fish nor fowl. Unfortunately, that is where the eurozone appears to be headed.
The trend toward renationalization has been clear. Since the end of the credit boom in 2008, cross-border claims of banks based in the eurozone core (essentially Germany and its smaller neighbors) toward the eurozone periphery have plummeted from about €1.6 trillion ($2.2 trillion) to less tan half that amount. (Part of the difference has ended up on the European Central Bank’s (ECB) balance sheet, but this cannot be a permanent solution.)
This trend might well continue until cross-border claims become so small that they are no longer systemically important – as was true before the introduction of the euro. At the current pace, this point might be reached within a few years. The financial integration brought about by the euro would be largely unwound.
Officially, renationalization is anatema. But it has its benefits. The system-wide impact of national shocks is less severe when cross-border debt is low. A bank default in any one country would no longer trigger a crisis elsewhere, because any losses would stop at the border.
Moreover, national banking systems can now separate more easily, because the peripheral countries’ current accounts have already achieved a rough balance, with all but Greece expected to record a small external surplus in 2014. With the exception of Greece, the peripheral countries will not need any capital inflows in the near future.
This is a key development. A few years ago, countries like Spain and Portugal were running large current-account deficits and needed capital inflows totaling roughly 10% of their GDP. The breakdown of cross-border bank lending thus represented a powerful negative shock for them. But, with current-account surpluses, renationalization of banking, by limiting the international transmission of financial shocks, can be a stabilizing force.
This is not a theoretical proposition. Italian savers, for example, still hold a significant volume of foreign assets (including German bonds), and foreign investors still hold a sizeable share of Italian government bonds. But interest rates on longer-term Italian government bonds (and Italian private-sector borrowing costs) are about 250 basis points higher than those on the German equivalents (this is the risk premium). Under full renationalization, Italian investors would sell their foreign assets and acquire domestic bonds, which would insulate Italy from financial shocks abroad and lower the interest-rate burden for the economy as a whole.
Meanwhile, foreigners still hold Italian government bonds worth about 30% of GDP. If these bonds were acquired by Italian investors (who would have to sell an equivalent amount of low-yielding foreign assets), Italians would save the equivalent of 0.73% of their country’s GDP. Any risk premium that the Italian government might still have to pay would no longer go to foreigners, but to Italian savers, whose incomes would increase – a net gain for the country.
Moreover, if Italians held all Italian public debt, any increase in the risk premium would be less burdensome. Even if the risk premium doubled, to 500 basis points, the Italian government’s debt-service costs would rise, but the money would be paid to Italian investors (whose higher incomes could then be taxed away).
The opposite of the renationalization scenario is complete integration of eurozone financial markets. Officially, this is the aim of establishing a European banking union. With a full banking union, cross-border lending should resume and remain stable, as common institutions would absorb national shocks. Interest rates would then converge to a low level, fostering recovery in the periphery and making it easier to stabilize public finances.
Unfortunately, a full-fledged banking union is unlikely to be achieved anytime soon. The ECB is set to take over supervision of the 120 largest banks, which account for the bulk of eurozone banking assets, but the next required steps are already in doubt. Most governments de facto oppose a single resolution mechanism (SRM in Brussels jargon), because it would mean that they could no longer control their own banks. Deposit insurance is not even being considered. And there are legal and political obstacles to creating a true common backstop.
As long as the fiscal backstops for banks remain national, there can be no level playing field. In this scenario, integration could at most take the form of “colonization,” under which banks from fiscally strong countries use their lower cost of capital to buy up banks in fiscally weak countries. Even in the unlikely event that colonization encountered no political resistance, it would not lead to a very efficient banking system.
The eurozone thus risks becoming stuck in an unstable status quo, with banks’ cross-border claims large enough to transmit national shocks to the entire system, but financial integration not deep enough to ensure that capital flows freely throughout the currency area. If a full banking union proves impossible, it might be preferable to let the trend toward renationalization run its course. At least the eurozone would get some stability.
Daniel Gros is Director of the Brussels-based Center for European Policy Studies. He has worked for the International Monetary Fund, and served as an economic adviser to the European Commission, the European Parliament, and the French prime minister and finance minister. He is the editor of Economie Internationale and International Finance.

Last updated: November 5, 2013 6:43 pm

Germany is a weight on the world
The US has as much right to complain as others had to complain about US failures
©Ingram Pinn
The criticisms that hurt are those one suspects might be fair. This might explain the outrage from Berlin last week over the criticism by the US Treasury of Germany’s huge and vaunted trade surplus. But the Treasury is to be commended for stating what Germany’s partners dare not: “Germany has maintained a large current account surplus throughout the euro area financial crisis.” This “hampered rebalancing” for other eurozone countries and created “a deflationary bias for the euro area, as well as for the world economy”. The International Monetary Fund has expressed similar worries.
The German finance ministry responded that its current account surplus wasno cause for concern, neither for Germany, nor for the eurozone, or the global economy”. Indeed, a spokesman stated that the countrycontributes significantly to global growth through exports and the import of components for finished products”. This reaction is as predictable as it is wrong. The surplus, forecast by the IMF at $215bn this year (virtually the same as China’s) is indeed a big issue, above all for the future of the eurozone.
To enlarge graph click here
Export surpluses do not reflect merely competitiveness but also an excess of output over spending. Surplus countries import the demand they do not generate internally. When global demand is buoyant, this need not be a problem provided the money borrowed by deficit countries is invested in activities that can subsequently service the debts they are incurring. Alas, this does not happen often, partly because the deficit countries are pushed by the supply of cheap imports from surplus countries towards investing in non-tradeable activities, which do not support the servicing of international debts. But in current conditions, when short-term official interest rates are close to zero and demand is chronically deficient across the globe, the import of demand by the surplus country is a “beggar-my-neighbourpolicy: it exacerbates this global economic weakness.

It is no surprise, therefore, that in the second quarter of 2013 the eurozone’s gross domestic product was 3.1 per cent below its pre-crisis peak and 1.1 per cent lower than two years before. Its highly creditworthy core economy is subtracting demand, not adding to it. Not surprisingly, the eurozone is also stumbling towards deflation: the latest measure of year-on-year core inflation was 0.8 per cent.

Since demand is so weak, inflation may well fall further. This not only risks pushing the eurozone into a Japanese deflationary trap but thwarts the necessary shifts in competitiveness across the eurozone. The crisis-hit countries are being forced to accept outright deflation. This makes ultra-high unemployment inescapable. It also raises the real value of debt. (See charts.)

The policies pursued by the eurozone, under German direction, were certain to have this outcome, given the demand-destroying impact of the all-round fiscal austerity. In a recent paper for the European Commission, Jan In ‘t Veld argues that contractionary fiscal policy has imposed cumulative losses of output equal to 18 per cent of annual GDP in Greece, 9.7 per cent in Spain, 9.1 per cent in France, 8.4 per cent in Ireland and even 8.1 per cent in Germany, between 2011 and 2013.
Inevitably, monetary policy is going to find it almost impossible to offset this. Before the crisis, it could work by expanding credit in what turned into the crisis-hit countriesabove all, in Spain. Today, it is working against the background of a weak banking system, debt overhangs in crisis-hit countries and an aversion to borrowing in creditor countries.
The most likely way that a more aggressive monetary policy would be effective is by depreciating the euro’s exchange rate. If, for example, the ECB were to undertake large-scale quantitative easing, by buying the bonds of the members in proportion to their shares in the central bank, a falling euro would be the most likely result. But that would exacerbate the tendency of the eurozone, operating under German influence, to force its adjustment on the rest of the world.

As the vulnerable countries shrink their external deficits, while the chief creditor country remains in surplus, the eurozone is generating huge external surpluses: the shift from deficit towards surplus is forecast by the IMF to be 3.3 per cent of eurozone GDP between 2008 and 2015. Given the shortfall demand in the eurozone, the shift might need to be even larger, at least if the vulnerable nations are to have much chance of cutting unemployment. This is a beggar-my-neighbour policy for the world. The US has every right to complain about it, just as others had a right to complain about past US regulatory failures.

It will be impossible, however, for the eurozone to achieve prosperity on the basis of export-led growth: it is too large to do so. It has to achieve internal rebalancing, as well. Hitherto, as the IMF’s October World Economic Outlook shows, it is mass shedding of labour that has raised competitiveness, and collapsing domestic demand that has reduced external deficits in the crisis-hit countries. Thus the adjustment successes have been the other side of the coin of economic slumps and soaring unemployment. Yet, even so, the IMF does not forecast significant reductions in net liability positions. Their vulnerability will endure.
So what, in brief, is happening? The answers are: creeping onset of deflation; mass joblessness; thwarted internal rebalancing and over-reliance on external demand.
Yet all this is regarded as acceptable, desirable, even moralindeed, a success. Why? The explanation is myths: the crisis was due to fiscal malfeasance instead of to irresponsible cross-border credit flows; fiscal policy has no role in managing demand; central bank purchases of government bonds are a step towards hyperinflation; and competitiveness determines external surpluses, not the balance between supply and insufficient demand.
These myths are not harmless – for the eurozone or the world. On the contrary, they risk either trapping weaker member countries in semi-permanent depressions or leading, in the end, to an agonising break-up of the currency union itself. Either way, the European project would come to stand not for prosperity, but for poverty; not for partnership, but for pain. This, then, is a tragic story.
Copyright The Financial Times Limited 2013

November 6, 2013, 11:55 AM ET

Global Central Banks Seek Shelter From Fed Tapering

By Anjani Trivedi


South Africa’s central bank is entering new territory, diversifying its foreign-exchange reserves by buying assets denominated in currencies such as the South Korean won and Australian and New Zealand dollars.

Daniel Mminele, deputy governor of the South African Reserve Bank, said this week that the bank is “acutely aware of the risks” of the U.S. Federal Reserve winding down its monetary stimulus and had decided to protect itself against the higher U.S. Treasury yields that are expected to result.

The South African central bank isn’t alone. Others are seeking to defend themselves against exposure to the U.S. dollar and euro, amid economic uncertainty and the Fed’s intention to begin winding down its stimulus, which is expected either later this year or early next year. Yields and prices move in opposite directions.

Foreign holdings of Treasurys fell by US$128 billion over five consecutive months to August, with Asian countries shedding more than US$70 billion in U.S. government bonds year to date, according to the latest data from the U.S. Treasury Department.

Analysts say they expect this trend to continue.

“From that point of view, it makes sense for reserve managers to try and reduce exposure [to Treasurys]. If yields are to rise, that will reduce the valuations of their portfolios,” said Khoon Goh, senior currency strategist at Australia & New Zealand Banking Group in Singapore.

Central banks in developing and emerging markets have also cut their allocations to the euro, data from the International Monetary Fund shows. Allocation of reserves by these banks to the euro declined from 28.5% in the second quarter of 2011 to 23.8% as of the second quarter of this year.

Instead, central banks and sovereign wealth funds are looking to the Korean won and the Australian, New Zealand and Canadian dollars given the countries’ investment-grade credit ratings and strong economic fundamentals.

Foreign holdings of Korean government debt have jumped 8% this year to 98 trillion won (US$92 billion), according to South Korea’s Financial Supervisory Service, although the share of foreign holdings remains well below levels seen in most other markets in Asia. Central banks in emerging and developing markets now hold 1.8% of their reserves in Australian dollars and 2.1% in Canadian dollars, according to IMF data.

Like other emerging markets, South Africa saw heavy fund outflows this past summer due to expectations that the Fed would soon begin withdrawing its monetary stimulus. The rand fell 10% and the nation’s foreign-exchange reserves dropped by 5%. The country has been plagued by a persistent current-account deficit, one of the largest among emerging markets.

Foreign exchange accounts for more than 80% of South Africa’s official reserves, which have fallen 3% to US$50 billion since the beginning of the year. Reserves act as buffers against currency shocks and South Africa isn’t adequately cushioned, Goldman Sachs said in a report on Tuesday. While emerging markets’ foreign-exchange reserves total an average of 21.9% of their gross domestic product, in South Africa the total is 11.4%.

Still, the markets for these alternate currencies such as the won are not as big and liquid as those for the dollar and yen, and South Africa’s diversification could have unintended and unpleasant consequences, investors say.

Increasing uncertainty over the direction of the major developed world currencies over the past three years has contributed to bouts of sharp and sudden movements in smaller, less-liquid currency markets,” said Robert Abad, an emerging-markets fixed-income portfolio manager at Western Asset, a subsidiary of Legg Mason Global Investment Management, which manages $656 billion.

Given this dynamic, a country with current-account vulnerabilities, such as South Africa, should focus on maintaining sizable and highly liquid foreign currency reserves in the event of unanticipated speculative pressure on the exchange rate.”

The South African Reserve Bank’s Mr. Mminele said the bank would also invest in new asset classes such as covered bonds, mortgage-backed securities and emerging-market local-currency debt and equities “to mitigate the potentially negative impact of rising bond yields on the reserves” and for portfolio management.

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Chase Isn't the Only Bank in Trouble

by Matt Taibbi

NOVEMBER 05, 2013
Businessman working on computer in office

 Allegations of multiple Wall Street scandals could have major implications

I've been away for weeks now on a non-financial assignment (we have something unusual coming out in Rolling Stone in a few weeks) so I've fallen behind on some crazy developments on Wall Street. There are multiple scandals blowing up right now, including a whole set of ominous legal cases that could result in punishments so extreme that they might significantly alter the long-term future of the financial services sector.

As one friend of mine put it, "Whatever those morons put aside for settlements, they'd better double it."

Firstly, there's a huge mess involving possible manipulation of the world currency markets. This scandal is already drawing comparisons to the last biggest-financial-scandal-in-history (the Financial Times wondered about a "repeat Libor scandal"), the manipulation of interest rates via the gaming of the London Interbank Offered Rate, or Libor. The foreign exchange or FX market is the largest financial market in the world, with a daily trading volume of nearly $5 trillion.

Regulators on multiple continents are investigating the possibility that at least four (and probably many more) banks may have been involved in widespread, Libor-style manipulation of currencies for years on end. One of the allegations is that traders have been gambling heavily before and after the release of the WM/Reuters rates, which like Libor are benchmark rates calculated privately by a small subset of financial companies that are perfectly positioned to take advantage of their own foreknowledge of pricing information.

A month ago, Bloomberg reported that it had observed a pattern of spikes in trading in certain pairs of currencies at the same time, at 4 p.m. London time on the last trading day of the month, when WM/Reuters rates are released. From the article:

In the space of 20 minutes on the last Friday in June, the value of the U.S. dollar jumped 0.57 percent against its Canadian counterpart, the biggest move in a month. Within an hour, two-thirds of that gain had melted away. 
The same pattern – a sudden surge minutes before 4 p.m. in London on the last trading day of the month, followed by a quick reversal occurred 31 percent of the time across 14 currency pairs over two years, according to data compiled by Bloomberg. For the most frequently traded pairs, such as euro-dollar, it happened about half the time, the data show. 
The recurring spikes take place at the same time financial benchmarks known as the WM/Reuters (TRI) rates are set based on those trades

The Forex story broke at a time when the industry was already coping with price-fixing messes involving oil (the European commission is investigating manipulation of yet another Libor-like price-setting process here) and manipulation cases involving benchmark rates for precious metals and interest rate swaps. As Quartz put it after the FX story broke:

For those keeping score: That means the world's key price benchmarks for interest rates, energy and currencies may now all be compromised.

Perhaps most importantly, however, there's a major drama brewing over legal case in London tied to the Libor scandal.

Guardian Care Homes, a British "residential home care operator," is suing the British bank Barclays for over $100 million for allegedly selling the company interest rate swaps based on Libor, which numerous companies have now admitted to manipulating, in a series of high-profile settlements. The theory of the case is that if Libor was not a real number, and was being manipulated for years as numerous companies have admitted, then the Libor-based swaps banks sold to companies like Guardian Care are inherently unenforceable.

A ruling against the banks in this case, which goes to trial in April of next year in England, could have serious international ramifications. Suddenly, cities like Philadelphia and Houston, or financial companies like Charles Schwab, or a gazillion other buyers of Libor-based financial products might be able to walk away from their Libor-based contracts. Basically, every customer who's ever been sold a rotten swap product by a major financial company might now be able to get up from the table, extend two middle fingers squarely in the direction of Wall Street, and simply walk away from the deals.

Nobody is mincing words about what that might mean globally. From a Reuters article on the Guardian Care case:

"To unwind all Libor-linked derivative contracts would be financial Armageddon," said Abhishek Sachdev, managing director of Vedanta Hedging, which advises companies on interest rate hedging products.

Concern over all of this grew even hotter last week with the latest Libor settlement, in which yet another major bank, the Dutch powerhouse Rabobank, got caught monkeying with the London rate.
Rabobank paid over a billion in fines to American, British, Dutch and Japanese authorities and saw its professorial CEO, Piet Moerland, resign as a result of the probe. The investigation revealed the same disgusting stuff all of the other Libor probes had revealedtraders and various other mid-level bank sociopaths laughing and joking about rigging rates and screwing customers all over the world. From the WSJ:

In a July 2006 electronic chat, an unidentified Rabobank trader was informed about the bank's plans to set Libor "obscenely high" that day, according to an exchange cited by the Justice Department. The trader responded, "oh dear . . . my poor customers . . . . hehehe!!"

Here at home, virtually simultaneous to the Rabobank settlement, Fannie Mae filed a suit against nine banks – including Barclays Plc (BARC), UBS AG (UBSN), Royal Bank of Scotland Plc, Deutsche Bank AG, Credit Suisse Group AG, Bank of America, Citigroup and JPMorgan – for manipulating Libor, claiming that the mortgage-financing behemoth lost over $800 million due to manipulation of the benchmark rate by the banks.

And virtually simultaneous to that, JP Morgan Chase disclosed that it is currently the target of no fewer than eight federal investigations, for activities ranging from possible bribery of foreign officials in Asia to allegations of improper mortgage-bond sales to . . . the Libor mess. "The scope and breadth of risky practices at JPMorgan are mind-boggling," Mark Williams, a former Federal Reserve bank examiner, told Bloomberg.

The point of all of this is that any thought that the potential Chase settlement might begin a period of regulatory healing for it and other Wall Street banks appears to be wildly mistaken. If anything, the scope of potential liability for all the major banks, particularly in these market-rigging furors, appears to be growing in all directions.

A half-year ago, it looked like the chief villains in the Libor mess at least were going to get away with writing relatively small checks. Back in March, a major private class-action suit filed by a gaggle of plaintiffs against the banks for Libor manipulation was tossed by a federal judge here in the southern District of New York on the seemingly preposterous grounds that a bunch of banks getting together to monkey with the value of world interest rates in this biggest-in-history financial collusion case was somehow now an antitrust issue.

The banks in that case humorously implied that the victims might have done better to sue for fraud instead of manipulation ("The plaintiffs, I believe, are confusing a claim of being perhaps deceived," one bank lawyer put it, "with a claim for harm to competition"), and the judge seemed to agree.

Moreover, when the plaintiffs' lawyers tried to make a point about the seemingly key fact that a series of governments had already concluded settlements with the banks for manipulating Libor, the judge – the Hon. Naomi Rice Buchwaldmocked the plaintiffs' lawyers for trying to ride to civil victory on a wave of government settlements:

Wait a second. Your job here, as plaintiffs' counsel, looking for whopping legal fees, is not to piggyback on the government. Indeed, the reason that there are statutes that provide plaintiffs' counsel with attorney's fees is a recognition that the government has limited resources.

The banks must have thought they'd hit the lottery, with this potentially deadly Libor suit suddenly stopped dead in its tracks by a grumpy federal judge with an apparent distaste for plaintiff lawyers who collect "whopping" legal fees. So the victims tried to take a different tack, appealing to a federal panel in an attempt to allow them to file their suits against the banks on a state-by-state level.

But then, in a seemingly fatal blow to the private claims, the U.S. Judicial Panel on Multidistrict Litigation ruled in favor of the banks, sending the case right back into the courtroom of the same judge who'd dumped on the plaintiffs' lawyers and their "whopping fees."

That was just a month ago, at the beginning of October, and back then it seemed like the banks might somehow escape the Libor mess with their necks intact.

Now, a month later, yet another bank has been forced to cough up a billion dollars for Libor manipulation, Fannie Mae has filed a major suit on the same grounds, and the Guardian Care Homes case is not only alive but looking like a threat to cancel billions of dollars' worth of Libor-related contracts. Not only that, many of those same banks are being sucked into what potentially is an even uglier scandal involving currency manipulation.

One gets the feeling that governments in all the major Western democracies would like to sweep these manipulation scandals under the rug. The only problem is that the scale of the misdeeds in these various markets is so enormous that even the most half-assed attempt at regulation will cause a million-car pileup.

There's simply no way to do a damage calculation that won't wipe out the entire finance sector when you're talking about pervasive, ongoing manipulation of $5-trillion-a-day markets. That's the problem – there's no way to do a slap on the wrist in these cases. If they're guilty, they're done.