Willem H. Buiter CBE, FBAProfessor of European Political EconomyLondon School of Economics and Political Science

1. The financial crisis of the north-Atlantic region that started in 2007 is, by most metrics, the biggest financial crisis ever

2. The global contraction of real economic activity that followed it will undoubtedly be the deepest and longest downturn since the Great Depression

3. If policy makers screw up, it could still become worse than the Great Depression

4. I don’t consider that likely

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Today’s advance industrial country financial crisis are rather like the EM crises of the 1970s, 1980s and 1990s. Dysfunctional banking and financial systems Frozen impaired financial markets Lack of fiscal spare capacity Convergence of public sector & banking sector

credit ratings (in a crisis, all debt is public) risk of ‘sudden stop’▪ Double crisis : banks and sovereign debt▪ Triple crisis: banks, sovereign debt & currency

Main difference from EMs: global reserve currency status of US & Eurozone

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Pay special attention to the inconsistent quartet Small country Large internationally exposed banking

sector Own non-global reserve currency Limited fiscal spare capacity▪ Iceland, Switzerland, Sweden, UK, Ireland (3

out of 4)

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After the banking crisis and the (private sector) financial crisis are we entering a period of sovereign debt crises and currency crises?

If so, will it be restricted to EMs and small countries (especially in CEE), or will it involve larger countries, including the UK & the US?

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Financial excesses (credit booms, asset bubbles) as bad in Eurozone as in US and UK Positive exceptions: ▪ Spain’s dynamic provisioning▪ Italy’s stay-at-home conservatism (except for UniCredit &

Intesa Sanpaolo ) Negative exceptions:▪ Spain’s wild construction boom/bubble▪ Ireland’s wild construction boom/bubble▪ Ireland’s banking bubble▪ Germany’s Landesbanken▪ Lending to CEE & Balkans▪ Lack of transparency of Euro Area banks; failure to recognise

losses & start recapitalisation▪ Euro Area behind US, UK and Switzerland in recognising bank

losses and addressing recapitalisation6

Real economy downturn at least as deep in Euro Area as in US & UK.

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Positive: Euro Area: Common Currency, LLR, MMLR European Commission (Competition

Directorate) attempts to preserve competition in banking despite egregious state aid & new banking Darwinism (survival of the fattest and the politically best-connected)

Less protectionism among EU members towards each other

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Negative No common policy on deposit insurance No common policy on unsecured creditors of

banks No common special resolution regime (SRR)

with structured early intervention (SEI) & prompt corrective action (PCA)

No common policy towards recapitalising banks No common policy towards guaranteeing assets

or liabilities, new lending or new borrowing No common fiscal stabilisation measures,

modulated according to ‘fiscal spare capacity’ Strong protectionism in financial and ‘posted

workers’ areas.9

... even if it is sound – something most crossborder north-Atlantic banks are not, but for past, present and anticipated future government financial support

Banks need: the Holy Trinity of financial stability1. Liquidity support (central bank as lender of last

resort & market maker of last resort)2. Solvency support (Treasury as recapitaliser of last

resort) Because of 1. and 2.

3. Banks get regulation & supervision10

Reasons banks become too big, too interconnected, too complex and too international to fail:1. Economies of scale2. Economies of scope3. Monopoly power (scale in a given activity)4. Conflict-of-interest synergies (bundling many

activities) 5. Lobbying power/political clout6. Tax arbitrage7. Regulatory arbitrage8. Desire to become too big, too interconnected, too

complex & too international to fail11

Too big to fail means too big to be private Public ownership of very large institutions Smaller private banks and other financial institutions▪ capital ratio requirements increasing in size of bank▪ More aggressive anti-trust & competition policy (European

Commission)▪ Separate investment banking from commercial banking▪ Prevent conflicts of interests within investment banks and

commercial banks by ‘unbundling’ further (Glass-Steagall on steroids)▪ No public (listed) companies in investment banking

No economic efficiency problems: ▪ economies of scale in banking exhausted before $100 bn balance

sheet.▪ Economies of scope non-existent (span of control and lack of focus

problems).

In the short term, fewer and larger banksIn the medium term, more and smaller banks 12

Classic example of market discipline undermined by political economy considerations

Too big to fail is a financial stability myth, but a powerful political economy reality

Orderly resolutions of bankruptcy/defaults/insolvencies of even the largest banks and financial institutions are easy

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Requires Special Resolution Regime with Structured

Early Intervention and Prompt Corrective Action – pre-empting Chapter 11 & Chapter 7: regulatory insolvency joins balance-sheet insolvency and liquidity insolvency .

Ability to ring-fence payment, settlement, clearing, custodial activities of banks (& possibly counterparties of banks also).

(Possibly) counterparties (CDS holders) senior to unsecured creditors

Clarity on the exact seniority ordering of all claimants

Political strength to resist pressure from unsecured creditors (pension funds, insurance companies, other banks) and other lobbyists

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Good Bank -Bad BankDeconstruction of RBS Group end-2008 Balance Sheet

(following theBulow-Klemperer-Hall-Woodward approach) (£ bn)

  RBS Good Bank Bad Bank

Assets      Clean assets (good & bad)

1,012 1,012 -

Toxic assets 325 325 -

Derivatives 993 993 -

Equity in other bank - - 460

Total assets 2,330 2,330 460

 

Liabilities      

Deposits 899 899 -

Debt securities & othernon-deposit liabilities

452 - 452

Derivatives 971 971 -

Total liabilities 2,322 1870 452

Equity 8 460 8

Total liabilities & equity 2,330 2330 460

 Capital ratio 0.34% 20% 1.7%

Central banks, Treasuries and regulators/supervisors are national

No more cross-border branches regulated & supervised by home country (Icesave)▪ EU principle of mutual recognition, single passport

RIP Only independently capitalised subsidiaries,

with own assets & liquidity; managed at arm’s length from parent & regulated & supervised by host country

Home country Treasury cannot be expected to bail out foreign subsidiaries of national banks

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Repatriation of cross-border banking

Special problems of the EMU1. One central bank for 16 countries2. No fiscal Europe3. No European regulator-supervisor for

border-crossing systemically important financial institutions.

4. Because of 2., credit easing by ECB/Eurosystem problematic: who recapitalises the ECB?

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Central bank’s conventional equity, W, need not be positive, but its comprehensive net worth,

V = W + S – E – T , must be positive, lest it either is at risk of failing to meet its financial obligations, or will have to raise S and thus future inflation to restore solvency.

Restoring solvency even through seigniorage may be impossible if the exposure of the central bank is to foreign currency assets or index-linked assets.

In that case only a low or negative realisation of T can restore central bank solvency 18

ECB itself small and irrelevant Eurosystem (ECB + 16 Euro Area NCBs)

large and relevant, but not fully integrated

NCBs share losses incurred as a result of Eurosystem monetary operations, liquidity operations and credit-enhancing operations

NCBs do not share losses incurred by NCB acting as quasi-fiscal agent for national Treasury

NCBs do no pool capital.19

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Assets (EUR millions)1 Gold and gold receivables 240,8172 Claims on non-euro area residents denominated in foreign currency 159,2993 Claims on euro area residents denominated in foreign currency 123,1014 Claims on non-euro area residents denominated in euro 21,359

5Lending to euro area credit institutions related to monetary policy operations denominated in euro

653,352

6 Other claims on euro area credit institutions denominated in euro 26,4537 Securities of euro area residents denominated in euro 292,4058 General government debt denominated in euro 36,7909 Other assets 241,523

Total assets 1,795,099

Eurosystem Assets, 08/-5/2009

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Liabilities (EUR millions)

1 Banknotes in circulation 759,502

2Liabilities to euro area credit institutions related to monetary policy operations denominated in euro

264,137

3 Other liabilities to euro area credit institutions denominated in euro 436

4 Debt certificates issued 0

5 Liabilities to other euro area residents denominated in euro 139,090

5.1 of which General government 130,717

6 Liabilities to non-euro area residents denominated in euro 177,993

7 Liabilities to euro area residents denominated in foreign currency 1,548

8 Liabilities to non-euro area residents denominated in foreign currency 11,407

9 Counterpart of special drawing rights allocated by the IMF 5,551

10 Other liabilities 159,64411 Revaluation accounts 202,95212 Capital and reserves 72,840

Total liabilities 1,795,099

Eurosystem Liabilities, 08-05-2009

Consolidated financial statement of the Eurosystem as at 8 May 2009: Bad news: Eurosystem has only €74 bn

of capital and reserves & €1,795 bn worth of assets, i.e. 24.6 times leverage

Good news: Eurosystem’s balance sheet is 20% of Euro Area annual GDP & monetary base (€1 trillion, 75% currency) is about 11% of GDP (€9.2 trillion) 22

With 4 % trend nominal GDP growth a reasonable seigniorage benchmark is 0.33% of GDP each year (currently €32bn)( required reserves are remunerated).

If long-term safe interest rate exceeds long-term growth rate of GDP by one percent, capitalised value of seigniorage is 33% of GDP, more than 1.5 times the balance sheet of the Eurosystem.

Safe but beware: growth of balance sheet of Eurosystem Financial development and crime-fighting could

reduce seigniorage revenue

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Is the ECB too independent to play a Euro-Area- or EU-wide role as regards macro-prudential supervision & regulation?

ECB may have to chose: independence and irrelevance or less independence and greater relevance.

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