I told you so
Revelations that the French government is considering an elite Eurozone (i.e., an inner core of Eurozone member states, excluding some of the existing members) have made it essential to analyse the possible results of the Eurozone’s break-up. Drastic contractual revisions would be inevitable, with major effects on the value (in terms of euro) of government bonds and inter-bank deposits. These two assets – usually regarded as being highly nominal-value-certain and hence very safe by banks – would see substantial changes in value. The resulting losses for some banks could destroy all of their capital.
If policy-makers were foolish enough in those circumstances to demand that banks “strengthen their balance sheets” (by shedding risk assets and/or assets that had lost much of their value) and “make themselves safer” (by operating with the minimum regulatory capital at all times and raising capital/asset ratios), the Eurozone could suffer an appalling plunge in demand, output and employment. It was these demands – i.e., that banks “strengthen their balance sheets” and add to their capital – that led to the cessation of money growth and the severe downturn of late 2008 and early 2009. The recent rhetoric of some of the key individuals in regulatory officialdom has indeed been depressingly similar to their language three years ago. Instead, what policy-makers should in fact ensure is that the quantity of money continues to grow, and that banks are given time (by means of a long-term, low-cost loan from the state) to rebuild their capital and assets. If a very severe slump threatens, the likelihood has to be that highly expansionary open market operations (similar to the “quantitative easing” adopted in the USA and UK) would be chosen by the European Central Bank and the key Eurozone governments. But it is alarming that until now the emphasis has been on bank recapitalization and the supposed need to make banks “safe”.
Banks’ vulnerability in severe financial crisis
Banks are undoubtedly very odd organizations compared with most companies and financial institutions in capitalist economies. The next few years in the Eurozone are likely to be a period of traumatic institutional upheaval, with the redefinition of the Eurozone‟s membership and the possible re-introduction of national currencies in some countries. Three points immediately present themselves:
i. The restoration of national currencies will be accompanied by extensive rewriting of contracts, which will have material redistributive consequences for creditors and debtors. Some banks could be heavy losers, with write-downs on both sovereign debt and loans to the private sector. As a result, the return of the drachma, lira and so on may well be associated with the wiping-out of banks’ capital in some countries. Gradual recapitalization (from profit retentions and loan write-backs) would be far more sensible than “Big Bang” recapitalizations of the kind seen, for example, in the UK in late 2008 and in Japan just before the Asian crisis of 1997 – 8.
ii. State-owned institutions – including probably the European Central Bank (or at any rate the Eurosystem of central banks) – will need more capital, as they also are “bust”. Watch out for a bogus method of recapitalization, often found in developing countries (including China).
iii. The combination of banks’ high gearing and the extraordinarily high level of yields now available on some Eurozone government bonds gives banks scope to make very high returns on capital from buying high-yield government bonds if the governments do not default.
Eurozone banks face huge losses relative to capital
Banks provide transactions services to their depositors. As the essence of transactions services is that they are conducted in “money” (i.e., an asset with 100% nominal value certainty, at least in principle), banks’ assets must also be characterized by nominal value certainty and – in that sense – be very safe. Safe assets generally offer low returns. In order to overcome the low returns and provide their shareholders with respectable returns on equity, banks are usually both highly geared (i.e., with high ratios of assets to equity and other kinds of capital) and fractionally reserved (i.e., with cash – which they must keep in reserve in order to hand back over the counter to depositors – a very low fraction of total assets).
In normal circumstances government bonds and inter-bank deposits are two of banks’ safest assets. Banks’ asset acquisition patterns in the initial successful period for the euro (i.e., from the introduction of the euro on a scriptural basis in 1999 to the closing of the inter-bank market in August 2007) reflected the almost universal belief in the safety of these two asset types. Government bonds issued by countries running very large current account payments deficits (such as Greece and Spain) were taken to be almost as credit-worthy as government bonds issued by Germany and the Netherlands. Similarly, confidence in the likely repayment of deposits left with banks headquartered in high-deficit Mediterranean countries enabled such banks to borrow heavily from other banks. With the onset of the severe phase of the Eurozone crisis since early 2010, the standard assumption about the safety of government bonds and inter-bank deposits has been destroyed. The press has begun to report open discussion among Eurozone member states of changes in the membership of the Eurozone. The contractual basis of the single currency is therefore in question. Two dangers may be highlighted, although this is just a small sample of the potential problems.
1. Change in currency denomination of government bonds. Everyone now accepts that Greece (and then almost certainly Cyprus, but perhaps with Italy, Portugal and Spain not far behind) could leave the Eurozone, and that the new Greek national currency (“the new drachma”) would lose value immediately relative to the euro. (The devaluation might be 30% or more.) Although Greece would soon see domestic inflation and a rise in the price level (and hence in national income), the ratio of public debt to GDP would soar if Greece continued to express its government debt in terms of euro. (In fact, for a devaluation of a third, the ratio of debt to GDP would rise 50%, i.e., from 160% to 240%, at one fell swoop.) Almost certainly the Greek government would redenominate its debt in terms of new drachma at the exchange rate prevailing just before the devaluation. (So – if the new drachma began life at par with the euro – the existing debt would be redenominated with the same figures, but in new drachma, not euro.) The result would be to inflict massive losses on all foreign holders of Greek government bonds in terms of the euro, because of the devaluation. (The precise relationship between such losses and the 50% “haircut” already proposed for private creditors of the Greek state is unclear to me and, I suspect, many others.)
2. Change in currency denomination of inter-bank lines. The departure of Greece from the Eurozone would be accompanied by the redenomination of both the “Greek” assets and liabilities of “Greek” banks. However, the notion of “Greek”-ness is difficult. Presumably, a deposit held by a Greek citizen who is resident in Greece in a Greek-owned bank located in Greece can – indisputably – be redenominated in new drachma. But – on any of the four implied dimensions (citizenship of depositor; residence of depositor; ownership of the bank taking the deposits; location of the bank taking the deposits) – the notion of “Greek”-ness could be diluted. (The deposit might be a German citizen resident in Greece etc.; the deposit might be by a Greek citizen resident in Germany etc…) The uncertainty about the correct currency denomination after Greece’s departure from the Eurozone is most critical with inter-bank deposits, since – as is well-known – the banks in the PIIGS group (Portugal, Ireland, Italy, Greece and Spain) funded their asset growth in the 1999 – 2007 period heavily from foreign banks. The obvious procedure for Greek banks with borrowings in euro from other Greek banks would be for these borrowings to be redenominated in new drachma. But what about borrowings from, say, German or Dutch banks? If the borrowings were redenominated in new drachma, the German and Dutch banks would take a capital hit reflecting the new drachma‟s devaluation. On the other hand, if the borrowings remained denominated in euros, a high probability is that Greek banks could not recover the loans in full in euro terms from their Greek debtors and – if the Greek banks then suffered losses which wiped out their capital – they could not repay the inter-bank borrowings anyway.
In short, banks in the Eurozone are likely to experience heavy losses over the next few years on assets which were supposed to be extremely safe as recently as early 2007. Further, the distribution of the losses between banks in different countries is open to negotiation and, at this stage, a matter of conjecture. Because of the ambitious gearing which is an inherent characteristic of banking, the losses on sovereign debt and inter-bank exposures will eliminate a high proportion of Eurozone banks’ capital. Again, the distribution of losses between the banking systems of different countries is already – and will remain for a number of years – the plaything of politicised bargaining (and lawyers’ interpretations of precedents, etc.).
The principal players in the Eurozone’s management have now realized the extremely dysfunctional character of the multi-government monetary union envisaged in the 1992 Maastricht Treaty and put in place over the following decade. But they can also see the appalling tensions – because the somewhat arbitrary redistributions that would occur because of contract redenomination – if the Eurozone were to dissolve or even to suffer a significant change in membership. They will therefore do whatever they can to prevent countries leaving the Eurozone.
Nevertheless, banks must make provisions on the losses that now seem inevitable on sovereign bonds and inter-bank exposures. The severity of the losses will depend not only on the contract redenominations, but also on underlying loan losses that would occur even if the Eurozone were intact. The severity of such underlying loan losses will depend – in turn – on the overall macroeconomic environment. If the Eurozone dissolves while prices (including the prices of the real estate which usually serves as banks’ loan collateral) are falling, more banking system capital will be destroyed than if the Eurozone breaks up in an inflationary context.
What does the analysis imply for policy towards the Eurozone’s break-up or, at any rate, its reformation? I have two main suggestions.
Policy suggestions 1: need for a burst of rapid money growth
The exact scale of the prospective banking system losses is uncertain. Of course, there is a risk that banks will attempt to downsize their assets and balance-sheet size in line with the erosion of their capital bases. A downward “debt deflation” spiral of the kind conceptualised by Irving Fisher in 1933 might then eventuate, with a crash in the quantity of money, and disastrous consequences for output and employment. A downward spiral of this sort must be avoided at all costs.
The simplest method of averting a debt deflation is for “the monetary authorities” (i.e., the central bank, but the central bank working with “the government”, which in the unfortunate case of the Eurozone means 17 governments) to engineer a sudden, big increase in the quantity of money. As I and others have argued on several occasions since the crisis began, an appropriate mechanism is for the authorities to buy back large quantities of government bonds with balances created by borrowing from the banking system (i.e., by the authorities – either the government or the central bank – exploiting their own credit-worthiness when private sector credit-worthiness has been shot to pieces). When the authorities credit the sellers’ bank deposits with the purchase money for the bonds, bank deposits (and hence money) increase. Assuming the operation is on a large enough scale and compressed into a short period of time, the effect – fairly quickly – is to ease balance-sheet strains throughout the economy, to spur gains in asset prices and so to motivate a recovery in spending. The Bank of England’s QE operations in 2009 and at present exemplify the implementation of a programme of this kind. I have written a great deal about QE and QE-type operations since 2008, and don’t want to repeat myself. At present the ECB is buying noticeable quantities of government bonds, choosing the bonds of governments that are in difficulties funding themselves from market sources. The media are making a fuss about these purchases. But the ECB’s operations are having only a limited effect on the monetary base, while M3 growth remains moderate at best (and may be about to turn downwards).
In my view, the governments of the Eurozone member states should agree among themselves that each of them will borrow from the commercial banking systems of their own countries, say, 5% of GDP in 2012, with the deliberate object of creating money. The ECB does not need to be involved in these operations as such, although it should of course be informed. The effect would be to shorten the average maturity of government debts which – in many ways – would be unfortunate. But, somehow or other, a burst of money growth is needed to prevent a ruinous debt deflation which could wipe out hundreds of billions of euros of bank capital, and would be accompanied by precipitous declines in demand and employment. If the Eurozone top brass (Merkel, Sarkozy, the Troika, etc.) are afraid of inflation, fair enough, but high inflation is not an imminent threat. They must also understand that a severe debt deflation would stigmatize the single currency idea in Europe for at least a generation and perhaps forever.
Policy suggestions 2: bank recapitalisation should be gradual
I have argued in several places that Big Bang bank recapitalization (i.e., comprehensive recapitalizations compressed into a very short period of time without regard to shareholders’ property rights) can be highly deflationary. The explanation is obvious enough if officialdom demands an increase in capital/asset ratios on the grounds that it wants banks to be safer. With capital given, an increase in K/A ratios must mean shrinkage of banks’ assets and hence of the deposits which constitute most of the quantity of money. But, even if officialdom does not press for an increase in K/A ratios and merely asks the banks to have more capital, the initial effect of the recapitalisation is to reduce the quantity of money. (Depositors’ claims on the banks – which were money – become claims on the banks in the form of equity and bonds, which are not money.)
Current developments in the Eurozone could lead to the wiping-out of many hundred billions of euros of bank capital. It is vital that banks continue to operate – in terms of handling their debtors – as if the capital were still there. They must not pull in loans, sell off securities and destroy money. They must be given time to rebuild their capital and to reorganize their balance sheets. In that interval banks’ operating profitability is likely to be handsome. As long as regulation is benign and friendly (which it most conspicuously has not been since 2008), capital will flow into the Eurozone banking system from banking systems across the world, and a major calamity should be prevented.
No one knows the changes in the composition and structure of the Eurozone that may emerge in the next few years. The banks could not have foreseen – and could not have been expected to foresee – the immense damage that these changes would inflict on their profits and capital. Strict adherence to the letter of the Basle capital rules could initiate exactly the debt-deflationary downward spiral that must be avoided. My suggestion is that
i. governments across the Eurozone extend low-cost loans to banking systems to compensate on banks’ balance sheets for the lost capital,
ii. these loans are to remain in place for the long period that is likely to be necessary for bank balance-sheet rehabilitation (which may well be longer than a decade),
iii. while the low-cost government loans continue, banks pay no dividends to equity shareholders,
iv. because of the long period of convalescence envisaged for the banks, they need merely to make provisions for expected bad debts and not to write off the full amounts they might eventually lose (and accountancy standards must be interpreted flexibly for some years),
v. the effect of iii. will be that all operating profits are retained for the rebuilding of capital, and
vi. once the rebuilding of capital has been on a sufficient scale, the banks repay the low-cost loans from the governments and operate in a normal fashion (i.e., with a high proportion of profits being distributed to equity shareholders).
The 17 Eurozone government need to reach a concordat on the size and terms of the loans they extend to their banks, since major competition issues could arise; they also – almost certainly – need some sort of exemption from the existing EU competition directives. The cheap loans are intended to give banks a period of grace to rebuild capital; they are not meant to facilitate unfair competition with banks from other EU countries. My guess is that a “normally operating” banking system (or systems) will return only in the mid- or late 2020s.
Tim Congdon is the founder of International Monetary Research Ltd.