Bundesbank makes the case that pursuing the Japanese Model makes the situation worse

In its 2012 Financial Stability Review, the Bundesbank looks at the fiscal and monetary policies being pursued under the Japanese Model for handling the EU's bank solvency led financial crisis and concludes they are making the situation worse.

The European sovereign debt crisis remains the greatest threat to financial stability in Germany.

A sovereign debt crisis brought on by Germany insisting that bank book capital levels and banker bonuses be protected.  As a result, countries have issued debt to bailout their banks.

The Bundesbank considers that a substantial worsening of the situation would have a significant adverse impact on German banks and insurers.

The significant adverse impact would be on banker bonuses if the German banks were required to recognize the losses currently hidden on and off their balance sheets.

As for the banks themselves, they could continue supporting the real economy even if they have low or negative book capital levels.

Banks in a modern financial system can do this because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers are the banks' silent equity partner when they have low or negative book capital levels.

In addition, low interest rates, high liquidity and potential exaggerations in the German real estate market could pose a future threat to financial stability.

Here is the nub of the problem.  All the policies that have to be pursued under the Japanese Model in order for the German banks to hide their losses result in very real threats to financial stability.

The risks to the German financial system are no lower in 2012 than they were in 2011.

The risks are actually increasing.

The European sovereign debt crisis actually came to a head at several points this year; Spain and Italy – two major economies – have been drawn into the crisis. Monetary and fiscal policy measures on a massive scale were therefore needed to stabilise the financial system.

Simply adopting the Swedish Model and requiring the banks to absorb the losses on the excess debt in the financial system would stabilize the financial system without resorting to monetary and fiscal policy measures on a massive scale.

“But monetary policy cannot eliminate the causes of the crisis; it can only buy time”, cautioned Sabine Lautenschläger, Deputy President of the Deutsche Bundesbank, at the press conference held today to present this year’s Financial Stability Review. She added that central banks had already done a lot to that end.

Since the beginning of the financial crisis, your humble blogger has been saying that monetary policy cannot address a bank solvency crisis, it can only buy time.

Time that should be used to force the banks to recognize their losses on the bad decisions they made when it came to extending credit or investing in sovereign debt.

“This has entailed an ever greater transfer of risk to the public sector and has caused the low-interest rate environment to become entrenched”, said Bundesbank Executive Board Member Dr Andreas Dombret, who is responsible for financial stability matters. He warned that “the side-effects of short-term stabilisation measures could leave a difficult legacy for financial stability in the medium to long term”.

The costs of pursuing the Japanese Model are huge.  They include greater transfer of risk to public sector and increased financial instability.

However, there is good news regarding German banks: they have lowered their leverage ratios, increased their tier 1 capital ratios and increasingly tapped more stable sources of funding, such as customer deposits. In addition, German banks have significantly reduced their claims on the countries hit by the sovereign debt crisis.

And think of all those bonuses paid to German bankers.

Who took on all those claims on the countries hit by the sovereign debt crisis?  Is there any chance that the German taxpayers' exposure has increased quite dramatically?

In mid-2012, however, the German banking system still had substantial exposures to Italy and Spain alone, of which just under €59 billion were to government debtors of both countries. 

“A substantial escalation of the sovereign debt crisis would, of course, have an adverse impact on the German financial system too”, warned Ms Lautenschläger....

Recognizing losses that are already on a bank's balance sheet does not create an adverse impact.  What creates an adverse impact is pursuing policies to pretend those losses don't exist. 

The Bundesbank, moreover, regards the low-interest rate environment as having negative repercussions on insurers. 

Bundesbank Executive Board Member Dr Andreas Dombret noted that “life insurers will have to continue making provisions in order to meet guaranteed rates of return in the future”.

So the Japanese Model basically comes down to:  killing the financial system to save it.

In view of the low interest rates, the Bundesbank has also focused its analysis on developments in the German real estate markets. Growth in housing prices in Germany’s urban centres is accelerating; exaggerated price developments in individual regional markets cannot be ruled out. 

Although he could see no signs yet of a rapid build-up of risks to financial stability in Germany, Mr Dombret warned that “the experiences of other countries show that precisely such an environment of low interest rates and high liquidity can encourage exaggerations on the real estate markets”, emphasising that this situation may also materialise in Germany's urban centres and pose a considerable threat to financial stability in this country.

What are the chances that financial regulators deflate the German real estate bubble before it can do considerable harm to the German economy?