by Don Alexander, MBA
Associate, RSD Solutions Inc.
As the European debt soap opera continues, Europe’s leaders have expressed their willingness to “do whatever it takes” to restore financial stability and save the euro. This is very similar to the Virginia dance that moves two steps forward and then one step back. Morris Goldstein, Stop Coddling Europe’s Banks (VOXEU, Jan. 11th), argues that policymakers’ actions too often serve the banks at the public’s expense.
Policymakers now acknowledge the wisdom of comments by IMF Head Christine Legarde at Jackson Hole (2011) about the need to recapitalize European banks. Goldstein indicates five concerns to address: incentives for deleveraging, guidelines for dividends and compensation, alternative macro scenarios for stress tests, burden sharing during restructuring and measures to address feedback loop on sovereign and bank debt.
The European Banking Authority (EBA), however, specifies a bank capitalization target (but not one made mandatory by national authorities) as a ratio to risk-weighted assets rather than converting that ratio into a target for bank capital alone. Banks may sell assets and tighten credit when new lending is needed.
The EBA advises banks to tap private-sector sources for recapitalization, but does not provide guidelines for either dividends or compensation. This is no directive for banks falling below the capital target on the payment of dividends or executive compensation.
The bank stress test scenario focused on mark-to-market losses on sovereign bonds and did not consider alternative macroeconomic scenarios (including much weaker euro area private forecasts). Bank capital positions were assessed only against a risk-weighted standard and not against an unweighted leverage target.
European Council, at the December Summit, decided to reverse its earlier position of private sector involvement; it announced that private-sector burden sharing would no-longer be required beyond the restructuring of Greek sovereign debt. This implies that the taxpayer will have to absorb any losses while the private-sector is the beneficiary of any upside potential.
Lastly, there is the problem of the adverse feedback loop between sovereign debt and bank debt. There are a number of long-term solutions, including a tougher fiscal compact, a bank capital target or a permanent financing facility. One short-term solution might involve the issuance of bonds with a risk-sharing mechanism.
While not mentioned in the paper, the slow plodding by EU policymakers, has not resolved the agency problem for European banks still subject to national regulation. As a result, these banks come under political pressure in their home countries to take additional sovereign bond exposure after any poor auctions. This has pushed a sovereign debt crisis into a banking crisis raising the risk of contagion and the cost of resolution. The temporary ECB liquidity facility provides a temporary solution and kicks the can further down the road.
If one examines the stance the official sector has taken toward banks, it looks like Euro zone leadership allows large banks to do what they please, even when they act in their own narrow interest rather than in the wider public one. It is not an optimal risk management paradigm of two-steps forward and one step back. It is time for a change.
For more information on this please follow the link: www.voxeu.org/index.php?q=node/7511
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