I was this morning reminded of the Chairman of Citicorp’s 1982 famous injunction that a country cannot go bust. What Walter Wriston said at the time of Mexico’s default on its debt to commercial banks was: "Countries don't go out of business....The infrastructure doesn't go away, the productivity of the people doesn't go away, the natural resources don’t go away. And so their assets always exceed their liabilities, which is the technical reason for bankruptcy. And that's very different from a company." But when it was reported today that the country of Iceland may indeed go bankrupt I wondered, not for the first time, where the bottom of this financial crisis may lay. There is a nice irony here in that this time it is banks that are threatened with bankruptcy and they require the help of the nation-states to bail themselves out. To some extent, the early 80’s debt crisis was the other way around.
Developments across European banks, starting with Ireland last week, really are quite disturbing. The unilateral guaranteeing of all deposits and Tier 2 debt is basically akin to the guarantee given by the UK government for Northern Rock last year after its bank run. But as we know this was insufficient to prevent its eventual nationalisation - as no buyer could be found. The guarantee stopped the run on the Rock as far as retail depositors were concerned but did not allow the bank to continue with its wholesale funding model. These recent decisions seem to have been made at the national level with no real consultation with the EC (and in this case the ECB) which as a side-issue will raise a pretty big question mark over co-ordination within the EU and the Eurozone.
But these or any guarantees do not address the fundamental problems of banks that have been far too reliant on wholesale funding and whose asset quality has deteriorated markedly. That problem has been replicated again and again in the UK and elsewhere in Europe. In the case of Ireland and Iceland it is also magnified as it is not one or two banks among many but the whole banking system which seems to have adopted the same model. A blanket guarantee does not help the quality of assets and hence funding liquidity - all it does is re-assure depositors (retail rather wholesale) that their money is as safe as the finances of the Irish state or Icelandic state.
So how much can individual European states help their banks? I plot here the ratio of the sum of major bank assets to GDP for the many of the main European nations (Source: http://www.ft.com/). The ratio tells us neither about the riskiness of each Euro of assets on the bank’s balance sheet nor about the capability of the state to capture its tax base, GDP, per se but does perhaps allow us to put the scale of the problems into some national context. And immediately we can see the scale of the Icelandic problem with bank assets at nearly 11 times GDP, where even a 10% default (if it was backed by the state) would increase public debt to GDP by nearly 110%. Under these circumstances the blanket guarantee would simply not be credible, as an increase of debt-GDP permanently of this size will require a permanent increase in the primary fiscal surplus by some 2-3%!
We also learn that Irish bank assets to GDP are around 250%, which is only around the Eurozone average (obviously not the UK, Iceland or Switzerland) and tells us that in asset terms the Irish banking system is perhaps no larger (or vulnerable) than that of the EZ average. But the extent of the fragility, which despite not having an excessive level of asset creation by international standards, was such that a government guarantee was required. And the need for this commitment device tells us something important about perceptions about the quality of bank assets and the likelihood of continuing funding.
The extent of heterogeneity of individual countries bank asset size is interesting and of particular note is the relative strength of the German state with respect to German banks with major bank assets at only around 140% of GDP. And that even though Italy looks superficially well off the raw number of 170% does not probably deal with the relatively poor credibility of the Italian fiscal authorities, where the provision of a guarantee may be proportionately more difficult. (That said the lending there may not have been quite so risky.) So even if the Irish and others have dealt with their banking stress with a government guarantee - if a scheme of this sort was to be extended to the whole of the Eurozone it is likely to need the guarantee of the German state.
This situation is not unlike trying to devalue a currency within a fixed exchange rate zone. The analogy is that other countries will not be happy with the unilateral increase in relative competitiveness. And there will be some pressure for a further round of devaluations (guarantees), which we have now seen. Most obviously those countries who are most vulnerable and whose assets are closest substitutes will be under most pressure to give a similar guarantee. And again that is what we are now seeing.
Given the juxtaposition of dwindling deposits and deteriorating assets, I would expect governments to will want banks to increase their Tier 1 capital, if at all possible, and that may mean some deals to be struck with Sovereign Wealth Funds and also perhaps the need for governments to take a direct capital stake in banks. Bank mergers will also be a regular event as the market compresses. But given that the root cause is poor quality assets, this may only be the first step on the road to a proliferation in TARPing or some form of insurance support for assets as well as liabilities in the Eurozone and elsewhere. The onus of the government or the public sector as a solution to the immediate crisis will mean that nation-states look likely to become inextricably linked to banks once again but this time as creditors.
Developments across European banks, starting with Ireland last week, really are quite disturbing. The unilateral guaranteeing of all deposits and Tier 2 debt is basically akin to the guarantee given by the UK government for Northern Rock last year after its bank run. But as we know this was insufficient to prevent its eventual nationalisation - as no buyer could be found. The guarantee stopped the run on the Rock as far as retail depositors were concerned but did not allow the bank to continue with its wholesale funding model. These recent decisions seem to have been made at the national level with no real consultation with the EC (and in this case the ECB) which as a side-issue will raise a pretty big question mark over co-ordination within the EU and the Eurozone.
But these or any guarantees do not address the fundamental problems of banks that have been far too reliant on wholesale funding and whose asset quality has deteriorated markedly. That problem has been replicated again and again in the UK and elsewhere in Europe. In the case of Ireland and Iceland it is also magnified as it is not one or two banks among many but the whole banking system which seems to have adopted the same model. A blanket guarantee does not help the quality of assets and hence funding liquidity - all it does is re-assure depositors (retail rather wholesale) that their money is as safe as the finances of the Irish state or Icelandic state.
So how much can individual European states help their banks? I plot here the ratio of the sum of major bank assets to GDP for the many of the main European nations (Source: http://www.ft.com/). The ratio tells us neither about the riskiness of each Euro of assets on the bank’s balance sheet nor about the capability of the state to capture its tax base, GDP, per se but does perhaps allow us to put the scale of the problems into some national context. And immediately we can see the scale of the Icelandic problem with bank assets at nearly 11 times GDP, where even a 10% default (if it was backed by the state) would increase public debt to GDP by nearly 110%. Under these circumstances the blanket guarantee would simply not be credible, as an increase of debt-GDP permanently of this size will require a permanent increase in the primary fiscal surplus by some 2-3%!
We also learn that Irish bank assets to GDP are around 250%, which is only around the Eurozone average (obviously not the UK, Iceland or Switzerland) and tells us that in asset terms the Irish banking system is perhaps no larger (or vulnerable) than that of the EZ average. But the extent of the fragility, which despite not having an excessive level of asset creation by international standards, was such that a government guarantee was required. And the need for this commitment device tells us something important about perceptions about the quality of bank assets and the likelihood of continuing funding.
The extent of heterogeneity of individual countries bank asset size is interesting and of particular note is the relative strength of the German state with respect to German banks with major bank assets at only around 140% of GDP. And that even though Italy looks superficially well off the raw number of 170% does not probably deal with the relatively poor credibility of the Italian fiscal authorities, where the provision of a guarantee may be proportionately more difficult. (That said the lending there may not have been quite so risky.) So even if the Irish and others have dealt with their banking stress with a government guarantee - if a scheme of this sort was to be extended to the whole of the Eurozone it is likely to need the guarantee of the German state.
This situation is not unlike trying to devalue a currency within a fixed exchange rate zone. The analogy is that other countries will not be happy with the unilateral increase in relative competitiveness. And there will be some pressure for a further round of devaluations (guarantees), which we have now seen. Most obviously those countries who are most vulnerable and whose assets are closest substitutes will be under most pressure to give a similar guarantee. And again that is what we are now seeing.
Given the juxtaposition of dwindling deposits and deteriorating assets, I would expect governments to will want banks to increase their Tier 1 capital, if at all possible, and that may mean some deals to be struck with Sovereign Wealth Funds and also perhaps the need for governments to take a direct capital stake in banks. Bank mergers will also be a regular event as the market compresses. But given that the root cause is poor quality assets, this may only be the first step on the road to a proliferation in TARPing or some form of insurance support for assets as well as liabilities in the Eurozone and elsewhere. The onus of the government or the public sector as a solution to the immediate crisis will mean that nation-states look likely to become inextricably linked to banks once again but this time as creditors.
