Monday, July 9, 2012

In support of a European banking union, done properly: A manifesto by economists in Germany, Austria and Switzerland

by Michael Burda, Hans Peter Grüner, Frank Heinemann, Martin Hellwig, Mathias Hoffmann, Gerhard Illing, Hans‐Helmut Kotz, Tom Krebs, Jan Pieter Krahnen, Gernot Müller, Isabel Schnabel, Andreas Schabert, Moritz Schularick, Dennis J. Snower, Uwe Sunde, Beatrice Weder di Mauro


July 9, 2012

The EU Summit decision on banking union is being questioned by some economists in Germany. This column argues that a banking union is a critical step in ending the EZ crisis and building a more stable EZ financial architecture. It is a translation by Michael Burda of the German-language manifesto drafted by the First Signatories listed below and signed by over 100 economists.

The financial crisis has exposed a fatal flaw in the design of European monetary union which can be removed only by decisive policy action. Policymakers in Europe now have an opportunity to change the game. A central aspect of this problem is the conflation between debt of the private sector and that of European national governments.

In the course of the crisis, fiscal budgets are being tapped to refinance systemically relevant financial institutions. At the same time, financial institutions continue to play a central role in financing national governments, lending money to them and holding their debt. An unavoidable consequence is that bank failures have led to sovereign debt crises and sovereign debt crises have led to banking crises, leading to growing mistrust of both national banking systems and government finance. The situation is aggravated by the fact that international investors, driven by fear of total collapse, have withdrawn funding to struggling countries, both for governments and for banks. This has in turn led to a balkanisation of national financial markets and threatens not only the European monetary union but the European integration project as a whole.

Only by breaking the link between the refinancing of banks and the solvency of national governments will it be possible to stabilise the supply of credit in crisis countries. If the refinancing of banks – and the insurance of bank deposits – can be made independent of the financial state of the respective domiciling country, national sovereign crises can be decoupled from the private sector financing. In this way, contractionary demand shocks induced by corrective national fiscal policy can be softened by a broadening of the supply of credit. A European backbone to the refinancing of banks will dampen the impact of the coming fiscal consolidation. An indispensable requirement for this is a set of uniform regulatory banking standards which are implemented by a single European authority.


1 comment:

kleingut said...

To be sure, to have a European banking supervision and a central bail-out institution which can recapitalize banks (and, if needed, wipe out shareholders' equity) are good proposals. Let me add something, though.

The idea that one can decouple banks and sovereign states in the EU through new institutions is a fairy tale. It is not a fairy tale in the US, but not only because the US has centralized bank supervision and a central Treasury.

Whenever the State of California goes bankrupt, the Californian Wells Fargo Bank (as well as other Californian banks) remains untroubled by this. Why? Because the Wells Fargo Bank’s creditworthiness can be determined on its own merits. If the bank’s loan portfolio is first class; if their risk management of trading activities is convincing; and if the bank makes a decent profit --- well, then very few people will care about the fact that the Wells Fargo Bank is located in a state which is bankrupt.

If, however, the Wells Fargo Bank had invested about one-third of its assets in Californian bonds and if the State of California could unilaterally decide to give up the USD as the currency and create new Flower Money --- well, then Californian banks would face a run as soon as their state goes bankrupt (probably way before then).

The greatest flaw is not the design of the monetary union but, instead, the Basel-II regulation that government bonds are risk free and do not need to be reserved against. No financial investment in the world is risk free; why would government bonds be?

This faulty Basel-II regulation prompted banks to run up “real” leverages to levels which the world has never seen: Deutsche Bank’s leverage is almost 40 to 1! In comparison, JP Morgan and Citigroup show leverages of around 10 to 1. Leverages at 20 to 1 or above have typically been reserved for hedge funds. From the standpoint of leverage, Deutsche Bank (and other large European banks) are more like hedge funds than like commercial banks. Even with a European banking supervision, Deutsche Bank will remain “coupled” with, say, Spain as long as it has huge amounts of Spanish bonds on its books.

What is the solution to restoring confidence in financial markets? One has to take all assets of questionable value (i. e. troubled government bonds) off the books of the banks and, going forward, one has to limit the amount of such bonds which banks can hold (establish risk provisions for them, too). Only when bank balance sheets reflect realistic asset values will confidence return to markets again.