BANK FRAGILITY MEANS RECOVERY REMAINS PRECARIOUS / THE FINANCIAL TIMES MARKETS INSIGHT ( A MUST READ )

Bank fragility means recovery remains precarious

By John Plender

Published: June 29 2010 18:09

After the Group of 20 meeting in Toronto and the passage of the US Financial Reform Bill, global economic recovery ought by rights to be in the bag. Yet the reality is otherwise. Like the fabled plane in the second world war, the global economy is limping along on a wing and a prayer, not least because the world’s debtor and creditor countries cannot agree on the way out of the present bind. In the meantime the financial system remains perilously fragile.

The onset of the Greek sovereign debt drama and the renewed funding difficulties of European banks has taken the crisis into new and challenging territory where, to change the metaphor, there is precious little left in the policymakers’ locker. As the newly published annual report from the Bank for International Settlements points out, Greece highlights the possibility that heavily indebted governments may not be able to act as buyers of last resort to save banks in a new crisis. If the debt of the government itself becomes unmarketable, the BIS adds, any future bail-out of the banking system would have to rely on external help. Yet where will the help come from?

Surely not from Germany, where taxpayer patience has already been exhausted after the €750bn ($914bn) “shock and awe” package for southern Europe. Whatever becomes of Angela Merkel’s troubled coalition, it is a safe bet that German policymakers will show little appetite for further public sector stimulus. Since those same policymakers seem to think they can export their way out of trouble while simultaneously demanding that their trading partners don a fiscal hair shirt, the prognosis for the eurozone looks dismal. The financial orthodoxy of the 1930s is back with a vengeance.

The picture of the banking system painted by the BIS is also disturbing. While banks have returned to profit and strengthened their capital ratios, new capital injected into banks has not quite matched losses revealed during the crisis. The profits are overly dependent on poor quality revenue from fixed income and currency trading, while in Europe there are doubts whether all crisis-related losses have been recognised. Meanwhile, the default risk on sovereign debt is not confined to Greece.

The European banking system would need more capital even if there were no uplift in the regulatory capital requirements in prospect from the impending Basel III regime. Yet too many investors, from sovereign wealth funds to conventional institutions, have burned their fingers advancing fresh capital to banks to be willing to put up more for such shaky prospects. Nor will fiscally stretched governments rush to pump more money into the political equivalent of a leper colony.

It is an unfortunate fact that the global economy remains hostage to the bankers. A variety of worthy reforms are now in place in the US and Europe, not all of them relevant to the causes of the crisis, not all of them tried and tested. And policymakers have conspicuously failed to take the measure of the big issue that matters: banks that are too important to fail, in a market that has become even more concentrated because of shotgun marriages and bail-outs. The new regulatory framework will probably place disproportionate reliance on tougher capital ratios to address this, though there remains a big question mark over how tough and over what period tougher ratios will come in. The lobbying power of the banks will continue to be deployed to dilute the whole re-regulatory agenda.

So where does this leave us? In the middle of an unprecedented and unnerving global experiment is the short answer. The reluctance of the world’s largest current account surplus countries to rebalance their economies towards consumption means that the deficit countries cannot put their balance sheets in order without subtracting from global demand. The split on fiscal management within the G20 between the US and the rest suggests the US may continue to impart some stimulus to the world economy, but at the cost of continuing global imbalance and potential currency turmoil.

The dollar’s role as the pre-eminent reserve currency is not at issue. Yet as Francis Warnock points out in a paper for the Council On Foreign Relations, the US now confronts a dilemma first identified in 1961 by the Belgian economist Robert Triffin.* To supply the world’s risk-free asset, the country at the heart of the international monetary system has to run a current account deficit. In doing so, it becomes more indebted to foreigners until the risk-free asset ceases to be risk-free.

The end-game to Triffin’s paradox is a global wholesale dumping of US Treasuries. The tipping point is inherently impossible to forecast. Given the lack of alternatives to the dollar, as I argued here two weeks ago, it is probably some way off. It is nonetheless surprising, given the high-wire nature of this global experiment, that investors’ risk appetite in general remains relatively robust.

*How Dangerous Is U.S. Government Debt? Capital Flows Quarterly.

The writer is an FT columnist

Copyright The Financial Times Limited 2010.