Der Spiegel calls for banking sector reform to save the euro

In a must read article, Der Spiegel concludes that saving the Euro requires banking sector reform.  Reform that did not occur in the aftermath of the 2008 crisis.

Time is running out. With the financial crisis now in its fifth year, the banks' problems remain unresolved, and in some countries they are even jeopardizing the stability of the state -- and the future of the European common currency.
Spanish banks are particularly unsteady. They are sitting on roughly €1 trillion ($1.3 trillion) in shaky loans related to the ailing real estate sector -- and urgently need fresh capital as a risk buffer. The estimates for the cash shortfall range from €50 billion to €200 billion.

One of the reasons I have argued against the Spanish government setting up a bad bank is that no matter what number is chosen for estimated losses, say 20% in this case, market participants can always argue that losses will be much higher.

Supporting this assertion are two simple facts.  Spanish unemployment is currently 24% and rising.  In addition, Ireland suffered a similar real estate bubble and prices for houses in Ireland are down 60% from the peak, as oppose to the mid-20s for Spain, and still falling.

These simple facts suggests that the 20% number reflects what the Spanish government can afford as oppose to economic reality.

Since such sums of money would overburden both the banks and the government budget, experts believe that the Spanish government should urgently seek help from the EFSF. 

But Spanish Prime Minister Mariano Rajoy is resisting this move, not just because the euro partners would basically have a say in governing the country, but also because his entire nation would then be branded as high risk -- and would probably find itself cut off from the international financial markets for a long time.  

Direct aid for banks from the euro countries is a sensitive issue, though. 

The German government rejects the idea flat out for fear that its money will disappear into a black hole. Sources at Germany's central bank, the Bundesbank, say they have no idea what's going on in the Spanish banks. 

This lack of knowledge is a consequence of a dangerously nation-centric approach that Europe has allowed to flourish in its financial industry. The sector is more internationally interconnected than any other, yet each country controls and, if necessary, rescues its banks on its own.

Regular readers will recall that both Sir Mervyn King at the Bank of England and the US Financial Crisis Inquiry Commission observed that the cause of the financial system freezing in 2008 was that market participants could not tell which banks were safe and which were not.

Here we are in 2012 and nothing has changed.

Banks are still not required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  This is the necessary information market participants, including other country's central bankers, need to determine the solvency of each bank.

Der Spiegel attributes the fact that ultra transparency has not been adopted to a nation-centric approach to regulating and rescuing the banks.

Your humble blogger disagrees.  If one country requires ultra transparency, then every country will require it, because to not require it is to put the country's banks at a competitive disadvantage.

The competitive disadvantage arises because market participants are able to do a better job of assessing the risk of banks that provide ultra transparency.  As a result, they provide these banks with lower cost funds and higher stock prices.

Banks that do not provide ultra transparency are assumed to be riskier because they must have something to hide.  As a result, market participants charge them more for funds and they sell at a lower stock price.

Clemens Fuest, a German economist who teaches at Oxford University and advises the German government, is convinced that, "without a fundamental reform of the European banking sector, the euro is in jeopardy." 

It is the financial industry, he argues, that repeatedly endangers the monetary union. Real estate bubbles such as the ones in Spain and Ireland could not have formed without the active help of local banks, he says. "The national watchdogs have failed to prevent this."

This is one of the major reasons that ultra transparency is needed.  It ends the dependence on regulators to prevent a financial crisis.

With ultra transparency, market participants, including other countries' regulators, can exert discipline to prevent a financial crisis.

Without ultra transparency, the market is dependent on national regulators preventing a financial crisis.  This is simply gambling with financial stability.

Following the collapse of Lehman Brothers, the Europeans continued as before -- which is a decisive mistake, says Daniel Gros, director of the Center for European Policy Studies (CEPS), a Brussels-based think tank. 

"Back in October 2008, ... every country focused exclusively on its own problems, and the European banking system "was, on the whole, not sufficiently stabilized," he contends. 

Take, for example, bank bailouts: Too many ailing institutions were kept alive by national funds, but at the same time EU conditions for receiving aid restricted their operations to a national level and further weakened the banks.

Bailouts which interfered with the way banks function in a modern financial system.

With deposit guarantees and access to central bank funding, banks are designed to absorb the losses on the excesses in the financial system today.  Subsequently, through the retention of earnings, banks rebuild their book capital levels.

By bailing out the banks before the losses were taken, not only were the sovereigns weakened, but the real economy was damaged.

What's more, the safety mechanisms to protect customer deposits are still organized on a national basis.

Your humble blogger has suggested that the simple reform for protecting customer deposits is to use the European Stability Mechanism and European Financial Stability Fund to backstop the sovereign guarantor.

Bank regulation is another example: Global banking groups like BNP Paribas and Deutsche Bank still have to deal with 27 different European national regulatory agencies, which often go to great lengths to hide information from each other....

Hiding information is a practice that must end as it perpetuates the practice of regulators gambling with financial stability.

Ultra transparency guarantees that every regulator has access to the current information they need when they need it.

While the German government fundamentally supports requiring banks to hold larger capital buffers, it is unclear how such large amounts of money can be raised so quickly....

Without ultra transparency, banks cannot raise large amounts of money.  What investor is going to invest where they cannot assess the risk of the investment because current disclosure leaves the banks resembling, in the Bank of England's Andrew Haldane's words, 'black boxes'?

What banks will do when faced with a higher capital requirement has already been shown with requirement to reach a 9% Tier I capital ratio.  Banks have reduced their lending, sold assets and changed their models to reduce the risk weights of the assets still on the balance sheet.  None of this helpful for supporting the real economy.

Fuest adds: "Spain has to relinquish the supervision of its banks to Brussels."

According to the economists, the case of Spain shows once again that the euro zone's approach to its banks is outmoded. The experts see ESM aid to Spanish financial institutions as the first step toward a far more integrated European banking market. 

Clearly the approach is outmoded as banks in a modern financial system do not need be be recapitalized in order to continue operating or supporting the real economy.

In the coming days, Gros will present a paper that proposes a joint European fund for insuring deposits and liquidating ailing banks. "It would make sense to create a European bank rescue fund, which would be financed through fees paid by the banks. This would take roughly 10 years," says Gros.

A joint European fund for insuring deposits makes sense and can be temporarily achieved by using the ESM and EFSF to backstop the sovereign guarantors.

Already one year ago, Fuest went on a tour to promote the idea of joint institutions in Europe. This week, the German parliament, the Bundestag, has invited him to attend a hearing. What the Oxford professor will recommend to the legislators is largely consistent with the proposals made by Gros and is nothing short of a minor revolution. 

"The national supervisory agencies have to be replaced by a strong European supervisory body," says Fuest. "National deposit insurance funds also have to be consolidated. Furthermore, there has to be a permanent European fund that rescues ailing banks or is able to liquidate them in an orderly manner." 

Fuest says that it still has to be discussed whether this should be achieved with money from the ESM, or a regular fee paid by European banks, or whether state guarantees alone should finance it.

With ultra transparency, there is no need to replace the national supervisory agencies.  They can easily work with a strong European supervisory body.

Economists are of course free to promote relatively unrealistic ideas -- but politicians are also under pressure on another front: Deutsche Bank CEO Josef Ackermann, who already proposed a European bank rescue fund back in 2009, says that such a fund is "more desirable than ever -- to stabilize banking systems, to restructure large international banks, to secure the domestic financial market and to avoid unfair competition due to national regulations." 

The re-nationalization of European banking markets is alarming, he says, and it stands in the way of the urgently needed growth in crisis-stricken countries.

It is not surprising that a banker favors a bailout fund.  Since the beginning of the financial crisis, bank bailouts have allowed bankers to continue to collect their bonuses.

Imagine how different the bonus payments to bankers would be if banks were not bailed out and allowed to function as they are designed.  In this case, banks would absorb the losses on the excesses in the financial system.

The result is likely to be a number of banks with very low or negative book capital levels.  Naturally, to rebuild these book capital levels, the banks will retain their future earnings and pay bonuses in stock.  Since shareholders dislike dilution, there would be substantial pressure to reduce the amount of stock paid as bonuses.

Many officials at the ECB also agree that the firefighting operations against the conflagrations in the industry finally have to be centrally organized. 

For weeks now, Draghi's new right-hand man, Jörg Asmussen, has been emphatically promoting the idea of a joint fund modeled after Germany's bank rescue fund, the Special Fund for Financial Market Stabilization (Soffin). And the ECB president himself said at a recent conference in Frankfurt that a strengthening of bank supervision and a safety net for banks have become more "urgently" needed on the European level. 

Strengthening bank supervision is easily achieved with ultra transparency.

But as pressure is growing to make banks a pan-European issue, there is also massive resistance to such plans....

The German government suspects that behind these proposals is an attempt to make strong countries like Germany foot a bigger part of the bill for bailing out banks.... 

Indeed, the German government wants to prevent the bailing out of Spanish banks from setting a precedent. Bailing out German banks at the taxpayers' expense has already not been particularly popular. Now, it would be virtually impossible to gain majority support in the Bundestag to prop up Spanish banks that gambled and lost on the country's construction boom. 

What's more, it would hardly end with bailouts for Spanish banks. Ireland, which only had to be bailed out by the rescue fund because of its banks, and thus has a much higher level of government debt than Spain, could insist on equal treatment....

It's a similar story with the European Commission, where many officials are opposed to special programs to rescue Europe's banks. "This would open Pandora's box," says one of the highest-ranking officials on the Commission.

Banks in a modern financial system do not require bailouts.  Between current book capital and the ability to retain future earnings, banks have more than enough access to capital to rebuild any temporary shortfall that results from recognizing losses on the excesses in the financial system.