Issues that need to be addressed to reduce European sovereign risk

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by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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European leaders face a deadline this Sunday to implement policies to help resolve the sovereign debt crisis.  A review of these issues is summarized in a recent commentary.

 

A deadline for solving a deadly Eurozone sovereign debt crisis (Guillermo de la Dehasa, VOXEU October 20^th) Time is running out for EU leaders to put an end to the Eurozone crisis.  European leaders face the following issues: 1. find a definitive solution to Greek insolvency, 2. isolate solvent countries from possible Greek contagion, 3. improve EU governance by creating a true European Parliament and 4. refocus on a pro-growth policy mix. 

 

Eurozone leaders must reach a clear and definitive solution to Greece’s insolvency without triggering a credit event.  Private sector involvement is not the best solution since “voluntary haircuts” can be an oxymoron and impede decisions.  Haircuts can be imposed on banks and a Brady-like swap program can be implemented for Greek bonds into European Financial Stability Facility (EFSF) bonds of longer maturities.  A challenge for policymakers is to isolate solvent members from contagion.  The can be implemented through a backstop for Eurozone member debt, such as a leveraged EFSF.  The guarantee is implemented in return for debt consolidation and structural reforms. 

 

Long-term, the present structure of European governance and crisis management needs to be addressed.  This issue can be resolved by amending the treaties and moving away from the current system where council decisions need unanimous approval within national governments.  Long-term, the EU needs to move to a federal system of governance by a true European parliament.  It should set up an independent European treasury to monitor states compliance to debt limits and structural reforms.  Lastly, policymakers need to implement a policy where Eurozone growth rate can exceed the real interest rate on its debt.

 

European banks will need to be recapitalized.  However, this will only be a stop gap measure without addressing the other issues.   Otherwise the concept of the euro will be at risk.    

 

The Cost of a Capital Cushion for Global Systemically Important Banks

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Recently, a number of financial institutions along with the International Institute of Finance (IIF), an industry association owned by financial institutions, have raised concerns about the economic costs for a capital cushion for global systemically important banks (GSIB).  The BIS has answered some of these questions in a recent report Assessment of the Macroeconomic Impact of Higher Loss Absorbency for Global Systemically Important Banks (BIS Macroeconomic Assessment Group, October 10^th).

Weakness in large financial institutions has often played a central role in the triggering and propagation of systemic financial crises.  The Financial Stability Board (FSB) and the Basel Committee on Banking have made a number of proposals for improving the loss absorbency of the GSIB and put together a Macroeconomic Assessment Group (MAG) to investigate the macroeconomic costs and benefits of these proposals. 

The GSIB proposal costs stem from the adverse impact on economic activity, bank policies to increase rate spreads and reduced lending to build up their capital buffers.  The 30 potential GSIBS, for the study, were based on their domestic market lending share and share of financial assets in their domestic economy.  

The initial result showed a 1% increase in the capital requirement reduced GDP by 0.06% over 8 years, or a little less than 0.01% per year.  The primary driver of this macroeconomic impact was the increase in lending spreads by 5-6 basis points.  The overall results conceal differences across countries related to role of the domestic financial system, existing capital buffers and international spillover effects.  It was found that by varying key assumptions: such as asset size, a larger bank list, a shorter implementation period or authorities altering only had a limited impact of growth. 

The MAG group looked at the full impact of implementation of all the Basel proposals and increased the capital buffer by an additional 2% for the GSIBs implemented over 8 years.  The actual results of the two components indicate reduced GDP growth by 0.04% per year while lending spreads rise by 31 basis points.  As noted earlier, different assumptions lead to different effects, while faster implementation or a weaker monetary response increasing the impact on GDP. 

The benefits for the GSIB framework relate primarily to the reduction in the exposure of the financial system to systemic crises that can have long-lasting effects on the economy and financial markets.

For more on this follow the link to the BIS:  http://www.bis.org/publ/bcbs202.htm