Europe is now at a crossroads: either closer political integration will support European economic integration or European markets will disintegrate at the cost of falling standards of living and rising international political tensions. It would not be the first time that a crisis compels Europe to take a step further on the road to closer political cooperation, as Avinash Persaud has argued on Vox. After describing the main challenges facing Europe in the midst of the financial crisis, I propose a program for European action.
The credit crisis has hit the heart of the banking system and…
The credit crisis has hit the heart of the financial system – losses of about $1 to $2 trillion in the US subprime market have eroded the banks’ reserves. Depending on the leverage implied by the reserve ratio (reserves as a percentage of outstanding loans), the maximum lending capacity was reduced by a multiple of these losses in reserves. On top of this, more risk-averse markets forced banks to maintain higher reserve ratios. Altogether, the crisis has cut current lending capacity by at least $20 trillion.
Figure 1. Interest rates capital market, January 1999 - March 2009
Note: Interest rate differential between 7-10 year BBB-rated corporate bonds and 10-year government bonds.
…reanimating the heart is difficult…
Despite high interest rates on bank lending implying an attractive return on bank equity (see Figure 1), recapitalising the banking system has been difficult for two reasons. The first is adverse selection. If a bank seeks new equity, investors interpret this as a signal that its assets are low quality. This mechanism also operates between countries – each individual country wants to signal that its banks are healthy.
A second, even more important, reason is a free-rider problem. Recapitalisation can start successfully only if somebody is prepared to take on past losses. Depositors, bondholders, and the government have a joint interest in eliminating this debt overhang, but they prefer to shift the burden of doing so to another party. Sweden successfully managed its credit crisis in 1991 because it quickly resolved the issue of burden sharing. Japan, in contrast, left the debt overhang in the financial system festering for too long in the 1990s.
…especially in Europe
In the case of a cross-border bank, the issue of burden-sharing is even more complex because more than one government is involved. In the United States, cleaning up the financial system is hindered by an ideological dislike of government intervention in financial markets. In Europe, in contrast, the difficulty of arriving at an arrangement of burden-sharing between the various European countries complicates the task of eliminating the debt overhang in the financial system. This explains why risk premiums for financial institutions in Europe exceed those in the US (see Figure 2). Moreover, taxpayers recapitalising banks often insist that the resulting additional lending capacity be employed in their own country.
This fragments European markets, harms economic activity in countries lacking large domestic banks and burdens intra-European relationships more generally.
Figure 2. Interest rate differential, all maturities, January 2007- 12 March 2009
Note: Interest rate differential between BBB-rated corporate bonds and AAA-rated government bonds, all maturities.
More demand for risk-bearing capacity…
With the credit crisis raising the costs of credit and dampening its availability, non-financial firms are turning to the equity market and the corporate bond market. On the supply side, however, investors are hesitant to buy equities and corporate bonds in view of the substantial investment risk (see the volatility of stock prices in Figure 3). Indeed, it is currently unclear whether the world in general and Europe in particular will become more fragmented economically or more integrated politically.
Figure 3. Volatility, 1999-2009
United States Euro area
a Volatility: for United States S&P 500, for Europe MSCI EURO STOXX 50.
b Volatility: implied volatility reflects the expected standard deviation of percentage changes in stock prices over a period of up to three months, as implied in the prices of options on stock price indices.
…is not being supplied at present by banks and financial markets…
In these insecure times, investors prefer to entrust their money to banks because bank deposits are covered by the deposit guarantee system. Even more importantly, investors realise that governments will not allow systemically important banks to go under after the disastrous experience with Lehman Brothers. Despite the inflow of deposits, the credit capacity of banks remains constrained. With banks lacking sufficient equity, the mismatch between a large demand for equity and corporate bonds and a large supply of bank deposits is not easily resolved.
…and must be supplied by taxpayers…
Governments must therefore step in. If governments do not absorb the supply of savings in the form of bank deposits by issuing government debt, this mismatch will lead to a serious contraction of aggregate demand. Governments could use the acquired capital to finance spending or to buy corporate bonds in order to stimulate private investment. In the latter case, taxpayers in effect take over the role of the banks’ equity in absorbing risks.
…who are fragmented in Europe
This option, however, raises important issues in the context of the EU. How, for example, should governments select corporate bonds without favouring domestic firms at the expense of foreign firms? A similar issue arises in the context of the ECB applying quantitative easing through the purchase of government and corporate bonds. Moreover, some European governments are poorly positioned to issue additional debt because financial markets question their solvency – in part because these governments are held liable for replenishing the reserves of banks that are large compared to their tax base. The fragmented nature of European fiscal powers thus complicates stimulating the European economy and, even more importantly, rebuilding confidence in the financial system and reducing tensions in the euro-zone.
Rights of shareholders
Another important issue raised by the demand for risk-bearing capital involves the position of shareholders. Shareholder activism is often identified as one of the causes of the crisis. Indeed, this activism was partly driven by regulatory holes in the supervision of the banking system – banks were allowed to take excessive aggregate risks with too little equity. Nevertheless, limiting the rights of shareholders across the board is counterproductive. It harms the supply of equity at a time when society is in urgent need of more risk-bearing capacity.
The previous analysis gives rise to the following roadmap for Europe in addressing the crisis in the financial system:
- Adopt European-wide rules for deposit insurance and burden sharing between various governments and debt holders if the reserves of banks become too low to safeguard deposits. Agreements on European burden sharing should ideally be consistent with regulatory responsibilities of the various countries.
- Provide some form of European guarantee to the governments facing financial distress, and provide a mandate to the ECB for quantitative easing so that the ECB can buy government bonds and private paper. The Stability and Growth Pact should be strengthened to fight moral hazard as a result of these guarantees.
- Provide clarity on the rights and duties of shareholders, for all industries, but for banks in particular, when re-privatising banks. If their reserves drop below a certain threshold, the suppliers of tier-1 capital should recapitalise the banks. If they fail to do so, the government must expropriate them.
- Impose coordinated sanctions against member states that use state aid to protect domestic industries.
- Harmonise rules for supervision of the financial sector across Europe to prevent regulatory competition from eroding the solvency of the financial sector.
- Facilitate global coordination between the US, China, and Europe by having Europe speak with one voice in international fora addressing global challenges such as climate change and creating open markets.