Why Weber is half right but completely wrong

In a recent interview with the Financial Times, the President of the German Bundesbank, Axel Weber, is quoted as saying: “I find it surprising that European institutions view crossborder operations within the EU as foreign operations”. There is, rather to my regret, nothing suprising about it.  As my colleague Charles Goodhart has said: (crossborder) “banks are international in life but national in death” (transcript of interview can be found here).

Regulation and supervision of banks in the EU is a mess; liquidity and solvency support of banks in the Euro Area is a mess.  Lender-of-last resort operations in the Euro Area need fiscal backing for the national central bank participating in it, including a full indemnity by the national treasury involved.  This is not a problem as long as the national identity of the bank is clear.  Whenever this in not the case, disaster can strike.

The Belgian, Dutch and Luxembourg authorities made a joint attempt to rescue the Fortis Group as a crossborder bank.  Crossborder fiscal burden sharing lasted a week.  Then the Dutch took 100 percent of the Dutch bit of Fortis, the Belgian authorities 100 percent of the Belgian bit and the Luxembourg authorities 100 percent of the Luxembourguese remnants.  If the Benelux cannot find its way to ex-post fiscal burden sharing, who can? Market-maker-of-last-resort operations in the Eurozone (including quantitative easing and credit easing operations) are restricted by the lack of clear fiscal burden-sharing rules for losses incurred by the Eurosystem as part of their monetary, liquidity and credit operations.

Banks require backing from the Holy Trinity of Banking: central bank, Treasury and Supervisor/Regulator

The starting point is that there is no such thing as a safe bank.  Even if a bank is sound, in the sense that, if held to maturity, its assets would cover its outstanding liabilities and other commitments, a bank borrows short and lends long and often illiquid.  This means that even a solvent bank is always at risk of not finding refinancing for its maturing liabilities or, in the case of deposits withdrawable on demand on a first-come-first-served basis, of a bank ‘run’.

For a bank to be safe therefore, the state has to guarantee its (re-) financing.  Individual banks could buy re-financing insurance in the market, but all banks collectively can only get insurance from an outside with deep liquid pockets.  For most banks, this back-up liquidity source is the national central bank – an agency of the nation state.  Deposit insurance, generally not provided by the central bank, is further, a belt-and-braces answer to the bank run problem, additional to the lender-of-last resort role of the central bank, which is to provide funding liquidity to solvent but illiquid institutions.  It also serves the social objective of protecting small depositors from loss and the economic efficiency objective of stopping small depositors from wasting time and other real resources verifying the creditworthiness of the institutions where they deposit their money.

In a modern financial system, where a significant amount of financial intermediation takes place through the capital market rather than through the banks, banks can obtain short-term liquidity also by selling liquid assets.  Liquidity in financial markets is, like funding liquidity, based on confidence, optimism and trust.  When they go, previously liquid assets can become effectively unsalable except as very steep discounts to their fair or fundamental value.  In that case, the modern central bank has a duty to provide liquidity to the markets by acting as market maker of last resort.  It can do this by purchasing temporarily illiquid assets outright from eligible counterparties, or by accepting them as collateral for loans, including repos, or at the discount window.   The prices for these illiquid assets can be established through a variety of mechanisms, including reverse auctions, models and the staring into the entrails of recently slaughtered chickens.

As we know, banks don’t just get illiquid but solvent (which could cause insolvency if the illiquidity lasted long enough), they become insolvent: even if all assets could be held to maturity, the banks would not be able to meet their obligations.  For a number of reasons, most of them obvious, the usual corporate insolvency procedures don’t work to well for banks.  It’s not very helpful, for instance, to have a standard ‘creditor standstill’ when your main business is credit.  In addition, some banks fulfil a role in the payments, clearing, and settlement systems and provide important custodial services for counterparties.  They can act as prime brokers, and provide market-making services, including their role in the tripartite repo market.  For all these reasons, the state takes a deep interest in bank insolvency.  Indeed, for large banks (often designated systemically important banks), the state tries to prevent bank insolvency through a variety of mechanism.

It is clear that the logic behind this unwillingness of the authorities to let the banks go broke rests on a simple but fundamental confusion between the life of a particular legal entity and the well-being of its stake holders and the ability of an organisation to fulfil certain systemically important functions.  Klemperer and Bulow have proposed a ‘stroke of the pen’ method for restoring the financial capacity of an under-capitalised bank.  Take the example of Commerzbank, Germany’s second largest bank, which has been offered  euro 18.2 billion in German state support.  If Commerzbank needs additional capital and cannot get it in the market, and if Commerzbank is deemed systemically important, it could (and should) have been put into a special resolution regime for banks and split into a good bank (Gute Commerz) and a bad bank (Schlechte Commerz).  Gute Commerz would have all the assets of the old Commerzbank – Alte Commerz -, but only the insured deposits on its liability side.  All other liabilities (the unsecured, uninsured creditors) would be put into Schlechte Commerz.  Schlechte Commerz would have the equity in Gute Commerz as its only asset.

Gute Commerz would be highly capitalised, after what amounts to a massive mandatory debt-into-equity swap.  The shareholders and unsecured creditors of Alte Commerz are no worse off than they would have been had Commerzbank/Alte Commerz been liquidated.

This whole exercise could be done in about 15 minutes.  Gute Commerz would continue to operate much as Alte Commerz did before, but with massively more capital.  It may be necessary in some countries to establish in law the seniority of insured depositors over other unsecured creditors.  Dr. Weber should focus his energies on getting such legislation passed in Germany, and indeed in the entire Euro Area and EU.  It may even be necessary to single out certain claimants on the bank (e.g. some counterparties of Alte Commerz in the derivatives markets, such as the CDS markets) for retention as counterparties of the Gute Commerz rather than putting them into Slechte Commerz.  Again, that would require legislation establishing the seniority rankings of different unsecured creditors and holders of contingent claims on banks.  I am unconvinced by the argument that certain counterparties of the banks should be made senior to other unsecured creditors, but as long as a sufficient number of unsecured creditors of Alte Commerz are sent into Slechte Commerz, it does not affect the viability of the Bulow-Klemperer proposal.

But in the blinded. blinkered and/or captured environment of those supervising and regulating banks, the prevention of insolvency of systemically important institutions still is part of the Confession of Faith, so in practice, fiscal authorities with deep, long-term non-inflationary pockets stand behind insolvent banks to re-capitalise them, to guarantee their bad assets or take them off their books and to subsidise them in a variety of ways.

With banks backed as regards liquidity support by the central bank and as regards solvency support by the Treasury, regulation and supervision become unavoidable, both for economic efficiency and for political reasons.  Excessive risk taking will result when you know liquidity will always be on tap at the central bank, and when recapitalisation to make up for survival-threatening losses is but a phone call away.

So every systemically important bank will be back by the Holy Trinity of Banking: the central bank, providing lender-of-last-resort and market maker of last resort support, the Treasury, providing capital support to prevent insolvency, and the Regulator/Supervisor making sure that the presence of the first two members of the Holy Trinity does not create too crazy incentives for excessive risk taking by banks.

In the EU, bank supervision/regulation is national

Let me quote from the Commission’s website: The Commission’s policies in the field of regulation of banks and financial conglomerates contribute to the relevant sections of the financial services action plan. These policies are based on the principles of mutual recognition and the “single passport”, a system which allows financial services operators legally established in one Member State to establish/provide their services in the other Member States without further authorisation requirements.” This means that foreign branches of a bank are regulated and supervised by the home country (parent bank country) regulator/supervisor.  This brought us the Icesave disaster where UK, Dutch and German branches of Landsbanki raised billions in deposits in these countries without any effective regulation or supervision from the home country (Icelandic) regulator/supervisor.   It is highly unlikely that these branches would have been able to operate in the UK, the Netherlands and Germany had they been subsidiaries, and therefore regulated and supervised by the host country supervisor-regulator.

Branches have no capital of their own in their host countries, liquidity is centrally managed and all key financial, strategic and often even operational decisions are made by the parent.  They are regulated/supervised by the home country regulator/supervisor.  If they get any liquidity support, it will be through the parent and therefore, indirectly, from the home country central bank.  Although fiscal bail-outs are never part of the formal rules of the game, it is clear that the host country fiscal authority is most unlikely to bail out the branch of a foreign bank.  Branches expose the host country to risk and pain (think IceSave).  They are a thing of the past unless we get a European regulator/supervisor.

Many supposed subsidiaries are in fact little more than branches.  They are inadequately capitalised as stand-alone institutions.  Liquidity is often pooled with the parent and other members of the Group.  There is limited managerial independence.  They tend to be regulated and supervised by the host country.  If there is lender-of-last-resort support and market-maker-of-last-resort support, it will come from the host country central bank.  If there is bail-out support, it will be from the host country Treasury.  I cannot conceive of any European country that would bail out a foreign subsidiary of a domestic bank.

I believe that, unless we get a European regulator/supervisor and sufficient fiscal Europe, the only crossborder banking we will have will be very strong, independent subsidiaries.  These will be independently capitalised, with independent liquidity resources, managed at arm’s length from the parent, regulated and supervised by the host country and with lender-of-last-resort, market-maker-of-last-resort and recapitaliser-of-last-resort support, if any, coming only from the host country central bank and Treasury.

The jurisdiction of the financial regulator/supervisor and of the fiscal authority underwriting the solvency of the banks must be the same as the domain over which these banks operate.  This precludes a single European market for banking services under the current set of principles and practices. The central bank providing liquidity support to markets and banks in its jurisdiction, and in the process exposing itself to credit risk and other counterparty risk, has to have a recapitaliser of last resort in that jurisdiction.  This creates a special problem for the 16 countries of the Euro Area, because there is a single central bank for the 16 countries but no single fiscal authority (or even an ex-ante fiscal burden sharing rule) to back up the ECB/Eurosystem, should it suffer capital losses as a result of its monetary and liquidity operations.

Adair Turner, Chairman of the FSA, was right when he said we neither either more Europe or less Europe.  I strongly favour more Europe, because I would like to see a thriving crossborder EU market in banking services.  But unless we get (1) a European regulator/supervisor for European crossborder banks and other systemically important financial institutions, and (2) a rudimentary fiscal Europe, capable of recapitalising the Eurosystem and systemically important European crossborder banks and other systemically important financial institutions, we shall get less Europe.

But though I favour more Europe, I recognise that we are currently in an unsustainable halfway house.  Without deeper integration, we will get less Europe. Unless we integrate banking regulation and supervision and create a fiscal Europe adequate for the task of backing up crossborder banking (and the ECB/Eurosystem), we will witness the repatriation of crossborder banking and the re-creation of 27 national banking markets.

Increasing co-operation between national supervisors in the over time, as proposed by Weber, is not a solution to the problem of the breakdown of the “principle of mutual recognition and the “single passport” in the field of banking and other systemically important providers of financial products and services.   The de Larosière Report, published by the High Level Group on Cross-border Financial Supervision (why is there never a Low Level Group on anything?  Do those who set up such arrangements or participate in them no longer recognise how pompous and self-important it sounds?) made recommendations that don’t go far enough to be useful.  At the very least there must be a permanent supranational body that (a) sets uniform rules for crossborder banks and (b) monitors compliance in all member states and (c) has to authority to impose changes in national implementation/transposition of the common rules and enforcement of these rules.

Alongside the European regulator/supervisor, it would also be helpful to require all crossborder banks and other systemically important financial institutions to incorporate as SEs (Societas Europaea, European Limited company).

There is no fiscal Europe

Taxation and borrowing in the EU are strictly national prerogatives.  Of the European institutions, only the European Investment Bank borrows regularly in the capital markets.  The EU obtains most of its revenue through payments from treasuries of member states. It has three categories of revenue, none of which can be varied at the discretion of the European Commission or any other EU institution.  From Wikipedia:

“Traditional own resources are taxes raised on behalf of the EU as a whole, principally import duties on goods brought into the EU. These are collected by the state where import occurs and passed on to the EU. States are allowed to keep a proportion of the revenue to cover administration.

VAT based own resources are taxes on EU citizens as a proportion of VAT in each member country. VAT rates and exemptions vary in different countries, so a formula is used to create the ‘harmonised tax base’. The starting point for calculations is the total VAT raised in a country.

GNI based own resources currently forms the largest contribution to EU funding. A simple multiplier is applied to the calculated GNI for the country concerned.” Total revenue from all three sources is currently capped at 1.24% of GNI for the EU as a whole.

The EU can borrow, but only on a limited scale and for restricted purposes.  Its loans, for instance, cannot go to Euro Area members. Currently it provides macro-financial assistance, as a financial aid programme to assist non-member states; and balance of payments (BoP) support to member states that have not yet adopted the euro.  On 2 December 2008, the maximum outstanding amount of loans under the BoP programme was raised from € 12 billion to € 25 billion. As of February 2009, Hungary and Latvia have requested assistance under this instrument.

Because there is no fiscal Europe, border-crossing financial institutions like banks are at risk of not being bailed out in their foreign operations, unless these foreign operations are given a very clear foreign identity.  This, however, is likely to reduce the attractiveness of having a foreign operation.

The minimal fiscal Europe we need to have an integrated crossborder EU banking market is an ex-ante fiscal burden sharing rule.  Ex-post fiscal burden sharing rules result in partitioning along national lines.  A superior alternative would be a dedicated fund, paid into by the EU member states in proportion to their participation in the ECB’s share capital, say, that can be drawn upon to recapitalise the ECB/Eurosystem and the crossborder EU banks.  The best alternative, for this European federalist, would be a proper supranational mini-fiscal authority, with its own revenue-raising powers (up to some limit set by the European Parliament, say) and its own power to borrow.

Three cheers for Neelie!

Competition Commissioner Neelie Kroes is absolutely right when she insists that banks that get state aid must restructure by the anti-competitive distortions this state aid creates.  What we are seeing as the immediate consequence of the financial crisis and the state aid is the survival and growing dominance of the fattest and the politically best connected.  This new Darwinism of the banking sector has nothing to recommend it from the perspective of efficiency and fairness.  Supervisors and regulators like it, because the last thing a supervisor or regulator wants is a bank failure on his or her watch.  Fat, well-connected and with access to subsidised public funds, no bank ought to go under.  Job done!

Banking sector concentration is increasing very rapidly, partly through mergers, take-overs and liquidations, partly through the withdrawal of foreign banks.  In Germany, Commerzbank has swallowed Dresdner.  In the UK, Lloyds Group now combines the former Lloyds-TSB and HBoS.  The competition-distorting activities of Northern Rock since it came under public control and later public ownership are well-documented, as are the market-distorting consequences of the continued financial protection offered by the German state to its Landesbanken.  Increasing concentration can also be seen in the US and the Netherlands, and there will be more before this crisis and Great Contraction are over.

So aggressive pro-competitive interventions by the EU Competition Commissioner should be welcomed and encouraged.  I hope that we will also see, in the near future, measures to limit the size banks and their scope.  Size restrictions could be achieved by making the minimum regulatory capital requirement an increasing function of the size of the bank’s balance sheet.  Scope restrictions could be achieved by ruling out banks from entering activities involving a potential conflict of interest with their other activities.

So I share Axel Weber’s concern about the repatriation of crossborder banking. It is certainly unacceptable (and against EU law) for governments to require banks receiving national fiscal bailouts to give preference to domestic customers over foreign ones.  Unacceptable, but inevitable as long as taxation is national.

Repatriation of crossborder banking in Europe (and elsewhere) is unavoidable, even without EU-state-aid-rules-violating government pressure on lenders to favour domestic borrowers, unless we get a single European regulator/supervisor for crossborder banks and at least a rudimentary fiscal Europe, sufficient to recapitalise crossborder banks and, if necessary, the ECB/Eurosystem.  Simple commercial logic, constrained by the reality of national fiscal support and national regulation and supervision will ensure this repatriation of crossborder banking.  If we cannot get the additional integration, national banking sectors are the lesser of two evils – the other evil being a resumption of crossborder banking without a common regulator/supervisor and adequate supranational fiscal back-up.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website