The financial crisis struck the US harder and more quickly than it did Europe. The complete freezing of credit markets required an immediate and overwhelming intervention – and the American fiscal and monetary authorities delivered it. Between the Federal Reserve, Treasury and the Federal Deposit Insurance Corporation, approximately $13,000bn of credit support was arranged for financial institutions in late 2008 and 2009. There was no alternative to this massive reaction, and it worked. US credit markets are now healthy, and the recapitalised banking system is stable. History will look favourably on the boldness of America’s response.
In contrast, the European Union has had much more time to strengthen its financial institutions but hasn’t developed any of the necessary tools. Not a powerful and flexible central bank. Not an effective central banking regulator. Not a sufficient political consensus. As a result, the world has watched a steadily deepening sovereign debt problem metastasise into a full blown banking crisis. Global markets fear big losses on bank holdings of sovereign debt. And, total liabilities of eurozone banks are now estimated to exceed 300 per cent of the region’s gross domestic product. That’s exponentially higher than the comparable US ratio at the worst moment in 2008.
Germany and France recently committed to producing a bank rescue plan by November 3 but have provided no details. This is a golden chance to redeem the fading credibility of Europe’s leaders. Especially if they apply the blueprint of America’s banking intervention. Both what went right and what went wrong.
Most crucial is that the financial equivalent of overwhelming force is applied. The goal is to restore market confidence in the banks, not satisfy technical requirements on capital ratios. To achieve this always requires a larger commitment than financial markets are expecting. The International Monetary Fund originally estimated that at least €200bn of new capital was required. Despite other lower estimates, this is the right target.
This rule of overwhelming force will be the hardest for them to follow. It mandates that their painfully incrementalist mindset of the past 18 months be set aside. But, Europe is facing renewed recession. If this banking crisis is not truly solved, that will materialise. Then, its current political problems may look small.
Second, this bank recapitalisation fund – the “euro Tarp” – must reside in a central facility. The capital need is too big, and time is too short for each nation to handle its own banks. Had the US Tarp been divided among multiple parties, it would have failed. The natural central authority here is the European financial stability fund, provided that expanding it for this purpose doesn’t require approval of 17 different parliaments.
Third, the banks need direct infusions of equity. The US Treasury initially designed the Tarp to acquire bad assets from the banks, but then reversed itself and only made such equity investments. It realised that the banks needed permanent capital more than the sale of dubious assets at low prices. If the euro-Tarp does not follow this pattern, its actions will not be taken seriously by financial markets.
Fourth, the first round of bank investments should be made quickly and unilaterally. The US Treasury did not negotiate with the first ten banking institutions which, simultaneously, received Tarp capital. It determined the necessary amounts for each, developed identical terms, and directed that they be accepted. Realising their own fragility, the institutions agreed.
Fifth, these investments should be accompanied by further support from the European Central Bank. The US Tarp investments were supplemented by a program of FDIC guarantees on certain, senior bank borrowings. This way, bank balance sheets were strengthened from top to bottom. For European banks, a standby facility like this, which might or might not be necessary to activate, should come from the ECB.
Sixth, the euro Tarp investments must carry both strong protections and equity upside for the taxpayers. That means taking back preferred shares, not common stock; separately receiving long-term warrants to purchase new shares of bank common stock at current market prices; and restrictions on executive compensation, dividends and acquisitions until the preferred shares are redeemed in full by the banks.
Here, Europe can learn from an American mistake. The US Treasury sold its Tarp warrants as soon as it could. For political reasons, it wanted to quickly terminate its ownership positions in banks. But, this approach sacrificed future upside gains for taxpayers, which they deserved. The euro Tarp should take a longer term approach.
Finally, bank recapitalisations should be accompanied by credible stress tests, like those Washington applied. The European Banking Authority’s tests continue to be too lenient, and markets do not believe them. Stricter tests, however uncomfortable the results, are necessary for restoring confidence.
That eurozone banks require injections of government capital may be a blessing in disguise. The beleaguered EU leadership now has a fresh opportunity to rebuild market confidence and thwart recession. It need only apply the lessons of America’s banking rescue, which are right there in black and white.
The writer is founder and chairman of Evercore Partners and was US deputy treasury secretary under President Bill Clinton.
A ‘euro Tarp’ can’t fix the banks, and could even exacerbate the crisis
US Tarp was launched in 2008 in response to the banks’ losses on real estate lending and securities. Hence recapitalisation of the banks by the government was required. European banks had also made losses on their US investments, mainly residential mortgage-backed securities, and they also needed support from their governments.
In contrast today European banks are under water because the value of government bonds they hold has gone down. Their governments cannot get them out of this hole because the region’s banks and governments are now linked so closely that they should be considered to have a consolidated balance sheet. In effect, recapitalisation by national governments is just a shift from the left to the right pocket. This is why a “euro Tarp” will not solve the eurozone’s key problem: the loss of confidence in government debt.
A badly-designed bank rescue operation might actually make things worse. It would increase the burden on governments, in terms of outright debt and potential liabilities, thus depressing peripheral bond prices even further. It may even lead to a spread of the crisis to the eurozone’s core countries, with France as the most likely first victim.
The writer is the director of the Centre for European Policy Studies, a Brussels-based think-tank.