In its January Global Financial Stability Report Market Update (published January 28, 2009), the IMF has raised their estimate of credit losses from bad assets originated in the US and held by US and European banks to $2.2 trillion (from $1.4 trillion estimated in November).  It also estimates the combined need of US and European banks for new capital at $0.5 trillion. Finally, the Fund recommends that the authorities take the distressed assets from the banks’ balance sheets through ‘bad bank’ arrangements.

Note that we are no longer just talking of ‘toxic’ assets, that is, assets whose value cannot be assessed with any degree of certainty because of their complexity.  We are now talking about bad or impaired assets that include the toxic stuff but also a large chunk of plain vanilla assets (real estate loans, simple mortgage products, consumer loans, corporate debt) that have become impaired because the borrowers/issuers are at risk of going belly-up the old-fashioned way.  With a long and deep recession still ahead of us, the quantity of ‘conventional’ bad assets on the books of the banks will escalate. 

In a letter to the Editor in today’s Financial Times (28 January 2009), the Director-general of the Bank of Italy, and my esteemed former colleague at the EBRD, Dr Fabrizio Saccomanni, objects to some of the things I wrote in my post The Banca d’Italia and the re-nationalisation of cross-border banking on 24 January 2009, about the Bank of Italy’s new initiative in creating a collateralised inter-bank market or MIC (for Mercato Interbancario Collateralizzato).

I reproduce his letter here:

There is growing financial protectionism.  This is happening even within the Eurozone – in violation of the Treaty.  For instance, the Italian central bank (Banca d’Italia) has just created a Collateralised Interbank Market, where the Banca d’Italia will serve as the universal counterparty, guaranteeing settlement in case of default.  The arrangement is, however, only open to Italian banks (one per group).  In the current turmoil, the Banca d’Italia may be able to get away with an arrangement that clearly violates the Eurosystem’s principle of “equal treatment of institutions across the euro area”, but the ECB will want to get rid asp of anything that hints at balkanisation of the eurosystem and preferential treatment offered by NCBs to their national counterparties. The ECB asserts indeed that the general eligibility criteria for counterparties to national central banks “are uniform throughout the euro area”.

This finanancial protectionism is to a large extent the unavoidable consequence of the rediscovery, during the current financial crisis, that although banks and other financial institutions have become global, regulation and the fiscal capacity to bail out banks and other tottering financial institutions have remained national.  Consequently, we have seen two forms of re-nationalisation of banking and finance.

The Irish government just nationalised the third largest Irish bank, Anglo Irish Bank.  Even an Irish government guarantee of all the liabilities of the Irish banks was not enough to keep Anglo Irish afloat.  Bank of America has just received a second injection of capital from the US government -  $20bn this time.  It has also received a guarantee from the US Treasury, the FDIC and the Fed on all but the first $10bn of $118bn of potential losses on toxic assets.

Governments all over the world (including the British government with Northern Rock and Bradford & Bingley, the Dutch government with ABN-AMRO) seem to resort to full nationalisation only after everything else has been tried and has failed. Looking ahead it seems likely that all British high street banks, RBS, HBOS, Lloyds Banking Group, Barclays and HSBC will end up in (temporary) public ownership within the next year or so.  RBS is already 57 percent government-owned and the soon-to-be-merged HBOS and Lloyds Banking Group are 43 percent publicly owned.  All three need additional capital.  None of the three is likely to be able to get it from the market.

The UK Chancellor, Alistair Darling, has been busy repudiating the notion that the British government was planning to ‘print money’ to prevent deflation and stimulate the economy.  He was reported in the  Financial Times (January 9th, 2009) as saying :“Nobody is talking about printing money. There’s a debate to be had about what you do to support the economy as interest rates approach zero, as they are in the US.  But for us that is an entirely hypothetical debate”.

This statement of the Chancellor either represents a major manifestation of profound ignorance about what central banks do and how monetary policy is conducted, or a deliberate denial of an obvious fact, perhaps because the words “printing money” have unfortunate Weimar or Zimbabwe connotations.  Yet ‘printing money’  – that is, creating base money, either through the issuance of currency or by increasing the stock of commercial bank reserves held with the central bank –  is what central banks do in a fiat money world. They do this not just in Zimbabwe, but also in the US, in the Eurozone and in the UK.