A group of almost 100 prominent Europeans delivered an open letter to the leaders of all 17 eurozone countries on Wednesday. The letter said, in so many words, what the leaders of Europe now appear to have understood: they cannot go on “kicking the can down the road”. The road has been blocked by the German constitutional court which has found the law establishing the European financial stability fund constitutional, but declared that no further transfers are allowed without Bundestag authorisation. The leaders have also understood that it is not enough to ensure that governments can finance their debt at reasonable interest rates, they must also do something about the banking system.
Faced with the prospect of having to raise additional capital at a time when their shares are selling at a fraction of their book value, the eurozone’s banks have a powerful incentive to reduce their balance sheets by withdrawing credit lines and shrinking their loan portfolios. The banking and sovereign debt problems are mutually self reinforcing. The decline in government bond prices has exposed the banks’ undercapitalisation and the prospect that governments will have to finance recapitalisation has driven up risk premiums on government bonds.
The financial markets are now anxiously waiting for the leaders’ next move. Greece clearly needs an orderly restructuring because a disorderly default could cause a meltdown. The next move will have fateful consequences. It will either calm the markets or drive them to new extremes.
I am afraid that the leaders are contemplating some inappropriate steps. They are talking about recapitalising the banking system, rather than guaranteeing it. They want to do it country-by-country, rather than for the eurozone as a whole. There is a good reason for this. Germany does not want to pay for recapitalising the French banks. While Angela Merkel is justified in her insistence, it is driving her in the wrong direction.
Let me stake out more precisely the narrow path that would allow Europe to pass through this minefield. The banking system needs to be guaranteed first and recapitalised later. National governments cannot afford to recapitalise the banks now. It would leave them with insufficient funds to deal with the sovereign debt problem. It will cost the governments much less to recapitalise the banks after the crisis has abated, and both government bonds and bank shares have returned to more normal levels.
The governments can however, provide a guarantee that is credible because they have the power to tax. It will take a new legally-binding agreement for the eurozone to mobilise that power, and that will take time to negotiate and ratify. In the meantime, they can call upon the European Central Bank, which is already fully guaranteed by the member states on a pro-rata basis. To be clear, I am not talking about a change to the Lisbon Treaty but a new agreement. A treaty change would encounter too many hurdles.
In exchange for a guarantee, the major banks would have to agree to abide by the instructions of the ECB. This is a radical step but necessary under the circumstances. Acting at the behest of the member states, the central bank has sufficient powers of persuasion. It could close its discount window to, and the governments could seize, the banks that refuse to co-operate.
The ECB would then instruct the banks to maintain their credit lines and loan portfolios while strictly monitoring the risks they take for their own account. This would remove one of the main driving forces of the current market turmoil.
The other driving force – the lack of financing for sovereign debt – could be dealt with by the ECB lowering its discount rate and encouraging countries in difficulties to issue treasury bills and prompting the banks to subscribe. The bills could be sold to the central bank at any time, so that it would count as cash. As long as they yield more than deposits with the ECB, the banks would find it advantageous to hold them. In this way, governments could meet their financing needs within agreed limits at very low cost during this emergency period, yet article 123 of the Lisbon Treaty would not be violated. I owe this idea to Tommaso Padoa-Schioppa.
These measures would be sufficient to calm markets and bring the acute phase of the crisis to an end. The recapitalisation of the banks should wait until then. Only the holes created by restructuring the Greek debt would have to be filled immediately. In conformity with the German demands, the additional capital would come first from the market and then from the individual governments. Only in case of need would the EFSF be involved. This would preserve the firepower of the fund.
A new agreement for the eurozone, negotiated in a calmer atmosphere, should not only codify the practices established during the emergency but also lay the groundwork for a growth strategy. During the emergency period fiscal retrenchment and austerity are unavoidable. But the debt burden will become unsustainable without growth in the long term – and so will the European Union itself. This opens up a whole new set of difficult but not insurmountable problems.
The writer is chairman of Soros Fund Management and founder of the Open Society Foundations
Europe’s dance of death between sovereigns and banks
George Soros is right in saying the discussion on recapitalisation of European banks is flawed. However, the best way to address the panic in the banking system is not through guaranteeing the banks, but through restoring full faith in the solvency of large eurozone economies instead.
Weaknesses in the European banking system have been known for some time, so why the sudden panic?
European Union policymakers have let Greece’s unique fiscal problems colour their prescription for countries such as Spain and Ireland which had banking, not fiscal, crises. Growth has also suffered in other countries, as austerity measures became fashionable. This economic slowdown, weak stress tests and the EU’s inability to handle the relatively small problems of Greece, combined to also erode confidence in Spain and Italy.
As interest rates paid by Italy and Spain soared, bond prices fell and led to deterioration in perceived soundness of banks holding these bonds. With more than €2,000bn in Spanish and Italian government bonds outstanding, even a small deterioration in their quality can put a significant dent in the capital banks hold. Investors and counterparties first shunned banks that held these bonds and then banks exposed to banks that held these bonds. Now we have a systemic crisis.
Today Europe is stuck in a dance of death between sovereigns and banks. In countries such as Ireland, banks have brought the sovereign to its knees, whereas in Greece the weakness of the sovereign has cost its banks dearly. Weak banks, such as some Spanish cajas, continue to weigh their sovereign down, whereas deteriorating sovereigns such as Italy are casting a dark shadow on the soundness of banks.
We must break this sovereign-bank loop and Mr Soros is right to point out that national level recapitalisation will only reinforce it. No amount of bank capital that could be raised, or guarantees that could be offered, would be sufficient to save European banks if doubts about the solvency of Italy and Spain are allowed to persist.
Greece was insolvent, but was it handled as though it had liquidity problems. Spain and Italy, which are solvent but illiquid, are being allowed to drift down towards bankruptcy through an insufficient provision of liquidity support. At this rate, they will take the EU banking system down with them.
The European Central Bank needs to provide an open-ended commitment to support illiquid countries and refinance their debt at affordable rates. It will make bond prices perk up and remove the biggest source of capital shortfall in EU banks. The European financial stability facility could step in, but only temporarily, if the ECB refuses to act.
Capital buffers can be built up through enacting a moratorium on bonus and dividend payouts, with the EFSF potentially supporting weak banks in weak countries. In the future, robust bank resolution legislation would help reduce the dangers weak banks pose to their sovereigns. Some form of eurobonds could be held by banks as protection against overexposure to weak sovereigns.
To restore growth, the callable capital of the European Investment Bank should be doubled to finance a growth-enhancing programme of investments in pan-European infrastructure. Greek debt stock needs to be brought down to not exceed the size of the country’s gross domestic product. Europe’s single-minded focus on austerity needs to go the way of its flawed bank recapitalisation plan.
The writer is managing director of Re-Define, an economic think tank, and visiting fellow at the London School of Economics.