Tuesday, July 10, 2012

A European banking union will not necessarily solve all problems!

It seems like a war among economists has started. First, around 170 German/Austrian economists rallyied around Prof. Hans-Werner Sinn in an open letter predicting no less than the expropriation of German savings. Then a group around Prof. Peter Bofinger published its rebuttal and called Prof. Sinn "irresponsible". And now a group of eonomists including the highly respected Beatrice Weder di Mauro (former member of the 5-person Council of Eonomic Experts) published a Manifesto for a European Banking Union.

What is this fuss all about? It's about the notion that a European banking supervision, a European deposit insurance and a European bail-out fund for banks would restore confidence in the Eurozone. The idea is "to de-couple banks and states". 

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 possibly 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). And no Banking Union could stop that run. On the contrary, banks outside California might end up in trouble, too.

The greatest flaw is not the design of the monetary union but, instead, the Basel-II regulation that government bonds are considered risk free, that they are not included in the calculation of leverage and that they 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.


  1. Meanwhile, Sweden and Finland don't want to pay for others debt. They even throw the idea of an UE departure (logical, because they will sink further with the new so called bailout funds).

    Banks and states will always go hand in hand. It only depends if some states will be willing to pay for another's banks.

  2. In the English translation, the opening remarks has "This column argues that a banking union is a critical *step* in ..." and the last paragraph starts with "A banking union can *help* ...". In between there nothing that says to me at least - "Here is THE ONLY SOLUTION".

    I have little doubt that the media in Germany, UK and elsewhere have posited the column in terms of "All We Need is a Banking Union", and then proceeded to ridicule its content and authors (especially the female Swiss Banker, as they did when she was advising Merkel), because that suits there political and banking mates.

    But nor will changing Basel II *alone*, restore so-called "market confidence" in the European Monetary Union. There is no Fairy Dust solution, but the markets, the politicians they pay and their media mates want Joe Public to believe such a thing exists, when they know darn well it doesn't.

    Maybe a Banking Union, a real Fiscal Union, a Deposit Insurance scheme, a Bank Bailout fund and changes to Basel could restore confidence in the EMU. But that will take at least a decade to implement, assuming it's even possible - which I seriously doubt.

    But even then the markets confidence won't be restored in the EMU, the US will NOT allow its position as the ONLY reserve currency to be challenged - if necessary it will go to war and drag Europe after it - against China and Russia.

    From what the Deputy Governor of the Norwegian Central Bank said in an [url=http://www.bis.org/review/r031223f.pdf]IBS meeting in Jakarta[/url] a few years ago, I understand that Norway's bank bailout mechanism is funded by the banks. And at that time it seems that model might be extended to other Nordic countries.

    Is there anything to learn from Norway's banking crisis of the late 80's early 90's? I get the impression that the Norwegian state may have turned a profit on fixing its banks.

    European people are more likely to take notice of what the Norwegians did 20 years ago; than take heed of what the Chicago Boys did in Chile 30 years ago, or the what was done or not done in Argentina 14 years ago.


    1. I am not familiar with the Scandinavian rescue vehicles but I remember a talk of one of their authorities (I believe he represented Sweden) who utterly critized the bail-out attempts of the EU (kicking the can down the road). He explained what Sweden had done with their banks and, if I recall correctly, it was very simily to what I am proposing: have them clean out their balance sheets by booking all possible losses; bring the state in as temporary holder of preferred stock (existing shareholders essentially wiped out); dress up the banks for the next wedding; sell preferred stock hopefully with a profit. Simple end of complicated story.

    2. Here is a better link to the BIS paper Jarle Bergo - Crisis resolution and financial stability in Norway

      Here is a detailed analysis (250 pages) Norwegian Banking Crisis it includes a comparison between what happened in Norway and Sweden, which in many respects were quite different, at least in how they were managed.

      There's a lot of material if you search "Norway Banking Crisis" - it seems to be largely ignored, yet perhaps it's more relevant than other oft quoted (including by me) crises elsewhere.

      Looks like Greece is becoming overshadowed by events in Spain. I read that some of the marching coal miners work at mines receiving state subsidies of up to 56,000 euros per annum per miner - another reminder of the UK under Old Labour in the 70's.


    3. I have looked through the shorter paper (Norway). I get the gist of it and that is correct. Right up my alley. The question is always: Who is calling the shots? Who is driving the process? The managements of near-bankrupt banks (which managements have a lot to do with their near-bankrupt situation) or the politicians who need to come up with tax payers' money to bail those bankers out. They replaced the Supervisory Board and much of management. The shareholders took a beating. Shocking? Heck no; only natural! At least in the capitalist business world.

      In Norway, the right people were calling the right shots. Perhaps Sweden differs but, as far as I can remember, in the essential points they came out the same way.

      Back in 2009, I was extremely disappointed by how "politely" Obama and his administration dealt with Wall Street. Nevetheless, compared to what the EU-elites did later, Obama was really tough as nails...

      I once wrote a piece titled "A Nueremberg trial for EU elites". My major point was that they wouldn't need to be convicted for not knowing how to handle things right but they should be convicted for not asking those who would have known better (and who actually offered their advice!).

      As Prof. Velasco said in his speech in Berlin (it's in my blog): "The sociology of economic thinking is such that if it happens in Chile, if it happens in Sweden or if it happens in Taiwan, it is not worth thinking about!"

      Sheer arrogance on the part of EU-elites. Or as the Spaniards would say: "Tontos con iniciativa".