By Adrian Blundell-Wignall
02/02/2012 - The financial crisis of 2008 was caused by the underpricing of risk in financial markets, threatening the banking industry worldwide. The emergency measures to save the industry led directly to the sovereign debt crisis in Europe, which in itself has exposed structural weaknesses in economic governance, jeopardizing the very existence of the euro region. Any attempt to avert an eventual fracturing of the currency union will need a set of policies that go further than the proposals currently under discussion. A true solution will look like this:
The European Central Bank should continue to support economic growth and investor confidence via term funding for banks and putting a lid on sovereign bond rates in key countries via its operations, including quantitative easing, well into the future.
The “Greece problem” needs to be resolved once and for all with a 50% (or larger) haircut on its sovereign debt and necessary ancillary policies, so that its chances of remaining in the euro improve.
Policymakers and political leaders should pursue a growth strategy with a balanced approach to fiscal consolidation and the gradual achievement of longer-run “fiscal compact” rules, combined with clear structural reforms including bank restructuring and recapitalization, labour and product market competition, and pension system reform. Without a growth strategy, the banking crisis is likely to deepen and the sovereign debt problems will worsen.
The recapitalisation of banks needs to be based on a proper cleaning up of bank balance sheets and resolutions where necessary. This can only be achieved with transparent accounting.
European banks are not only poorly capitalised, but also mix investment banking with traditional retail and commercial banking. Risk exposures in large, systemically important financial institutions (SIFIs) cannot be properly quantified let alone controlled.
Adrian Blundell-Wignall, Special Advisor to the OECD Secretary General on financial markets and Deputy Director of the Directorate for Financial and Enterprise Affairs.
These activities have to be separated. Retail banks where depositor insurance applies should not cross-subsidise high-risk-taking businesses; and these traditional banking activities should also be relatively immune to sudden price shifts in global capital markets. Traditional banks need to be well capitalised with a leverage ratio on un-weighted assets of at least 5%. These policies will improve, not diminish, the funding of domestic SMEs on which growth depends.
The ECB cannot lend directly to governments in primary markets and it cannot recapitalise banks: the role of the European Financial Stability Facility and European Stability Mechanism may be critical in providing a “firewall” via these functions; and it also provides an exit strategy mechanism for ECB holdings of sovereign debt on its balance sheet. The size of resources the EFSF/ESM may need for all potential roles, particularly bank recapitalisation, should not be under-estimated. This is not independent of what the ECB does, but it could be around € 1trillion.
The current EFSF/ESM resources of € 500 billion are not enough. Furthermore, the EFSF has not found it easy to raise funds at low yields, even with guarantees. If the size is not enough, then the paid-in capital and leverage ability may need to be raised and brought forward – the € 500 billion limit could apply to the ESM and not be consolidated with the € 440 billion resources of the EFSF. But if these structures as envisaged cannot raise enough funds from private investors, as seems likely, other funding sources will need to be brought in. The only plausible mechanisms are: a bank license to the EFSF and credit from the ECB (and increasing leverage); the International Monetary Fund is a “bank” and the ECB could lend to them the appropriate sums; sovereign wealth funds could be cajoled with appropriate guarantees (possibly via the IMF) to provide the funds.
Implementing these policies, along with a focus on growth and structural change, provide a chance for Europe to solve its problems without fracturing the eurozone. But this remains a risk.
Leaving the currency union permits countries to convert credit risk into inflation risk: monetisation of their debt and an exchange rate route to a growth strategy. Still, the cost for Europe as a whole of such an outcome would be large, and it is to be hoped that this can be avoided.