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  1. 1. Willem H. Buiter CBE, FBA Professor of European Political Economy London School of Economics and Political Science
  2. 2. <ul><li>The financial crisis of the north-Atlantic region that started in 2007 is, by most metrics, the biggest financial crisis ever </li></ul><ul><li>The global contraction of real economic activity that followed it will undoubtedly be the deepest and longest downturn since the Great Depression </li></ul><ul><li>If policy makers screw up, it could still become worse than the Great Depression </li></ul><ul><li>I don’t consider that likely </li></ul>
  3. 3. <ul><li>Today’s advance industrial country financial crisis are rather like the EM crises of the 1970s, 1980s and 1990s. </li></ul><ul><ul><li>Dysfunctional banking and financial systems </li></ul></ul><ul><ul><li>Frozen impaired financial markets </li></ul></ul><ul><ul><li>Lack of fiscal spare capacity </li></ul></ul><ul><ul><li>Convergence of public sector & banking sector credit ratings (in a crisis, all debt is public) </li></ul></ul><ul><ul><li>risk of ‘sudden stop’ </li></ul></ul><ul><ul><ul><li>Double crisis : banks and sovereign debt </li></ul></ul></ul><ul><ul><ul><li>Triple crisis: banks, sovereign debt & currency </li></ul></ul></ul><ul><ul><li>Main difference from EMs: global reserve currency status of US & Eurozone </li></ul></ul>
  4. 4. <ul><li>Pay special attention to the inconsistent quartet </li></ul><ul><ul><li>Small country </li></ul></ul><ul><ul><li>Large internationally exposed banking sector </li></ul></ul><ul><ul><li>Own non-global reserve currency </li></ul></ul><ul><ul><li>Limited fiscal spare capacity </li></ul></ul><ul><ul><ul><li>Iceland, Switzerland, Sweden, UK, Ireland (3 out of 4) </li></ul></ul></ul>
  5. 5. <ul><li>After the banking crisis and the (private sector) financial crisis are we entering a period of sovereign debt crises and currency crises? </li></ul><ul><li>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? </li></ul>
  6. 6. <ul><li>Financial excesses (credit booms, asset bubbles) as bad in Eurozone as in US and UK </li></ul><ul><ul><li>Positive exceptions: </li></ul></ul><ul><ul><ul><li>Spain’s dynamic provisioning </li></ul></ul></ul><ul><ul><ul><li>Italy’s stay-at-home conservatism (except for UniCredit & Intesa Sanpaolo ) </li></ul></ul></ul><ul><ul><li>Negative exceptions: </li></ul></ul><ul><ul><ul><li>Spain’s wild construction boom/bubble </li></ul></ul></ul><ul><ul><ul><li>Ireland’s wild construction boom/bubble </li></ul></ul></ul><ul><ul><ul><li>Ireland’s banking bubble </li></ul></ul></ul><ul><ul><ul><li>Germany’s Landesbanken </li></ul></ul></ul><ul><ul><ul><li>Lending to CEE & Balkans </li></ul></ul></ul><ul><ul><ul><li>Lack of transparency of Euro Area banks; failure to recognise losses & start recapitalisation </li></ul></ul></ul><ul><ul><ul><li>Euro Area behind US, UK and Switzerland in recognising bank losses and addressing recapitalisation </li></ul></ul></ul>
  7. 7. <ul><li>Real economy downturn at least as deep in Euro Area as in US & UK. </li></ul>
  8. 8. <ul><li>Positive: </li></ul><ul><ul><li>Euro Area: Common Currency, LLR, MMLR </li></ul></ul><ul><ul><li>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) </li></ul></ul><ul><ul><li>Less protectionism among EU members towards each other </li></ul></ul>
  9. 9. <ul><li>Negative </li></ul><ul><ul><li>No common policy on deposit insurance </li></ul></ul><ul><ul><li>No common policy on unsecured creditors of banks </li></ul></ul><ul><ul><li>No common special resolution regime (SRR) with structured early intervention (SEI) & prompt corrective action (PCA) </li></ul></ul><ul><ul><li>No common policy towards recapitalising banks </li></ul></ul><ul><ul><li>No common policy towards guaranteeing assets or liabilities, new lending or new borrowing </li></ul></ul><ul><ul><li>No common fiscal stabilisation measures, modulated according to ‘fiscal spare capacity’ </li></ul></ul><ul><ul><li>Strong protectionism in financial and ‘posted workers’ areas. </li></ul></ul>
  10. 10. <ul><li>... even if it is sound – something most crossborder north-Atlantic banks are not, but for past, present and anticipated future government financial support </li></ul><ul><li>Banks need: the Holy Trinity of financial stability </li></ul><ul><ul><li>Liquidity support (central bank as lender of last resort & market maker of last resort) </li></ul></ul><ul><ul><li>Solvency support (Treasury as recapitaliser of last resort) </li></ul></ul><ul><li>Because of 1. and 2. </li></ul><ul><ul><li>Banks get regulation & supervision </li></ul></ul>
  11. 11. <ul><ul><li>Reasons banks become too big, too interconnected, too complex and too international to fail: </li></ul></ul><ul><ul><ul><li>Economies of scale </li></ul></ul></ul><ul><ul><ul><li>Economies of scope </li></ul></ul></ul><ul><ul><ul><li>Monopoly power (scale in a given activity) </li></ul></ul></ul><ul><ul><ul><li>Conflict-of-interest synergies (bundling many activities) </li></ul></ul></ul><ul><ul><ul><li>Lobbying power/political clout </li></ul></ul></ul><ul><ul><ul><li>Tax arbitrage </li></ul></ul></ul><ul><ul><ul><li>Regulatory arbitrage </li></ul></ul></ul><ul><ul><ul><li>Desire to become too big, too interconnected, too complex & too international to fail </li></ul></ul></ul>
  12. 12. <ul><li>Too big to fail means too big to be private </li></ul><ul><ul><li>Public ownership of very large institutions </li></ul></ul><ul><ul><li>Smaller private banks and other financial institutions </li></ul></ul><ul><ul><ul><li>capital ratio requirements increasing in size of bank </li></ul></ul></ul><ul><ul><ul><li>More aggressive anti-trust & competition policy (European Commission) </li></ul></ul></ul><ul><ul><ul><li>Separate investment banking from commercial banking </li></ul></ul></ul><ul><ul><ul><li>Prevent conflicts of interests within investment banks and commercial banks by ‘unbundling’ further (Glass-Steagall on steroids) </li></ul></ul></ul><ul><ul><ul><li>No public (listed) companies in investment banking </li></ul></ul></ul><ul><ul><li>No economic efficiency problems: </li></ul></ul><ul><ul><ul><li>economies of scale in banking exhausted before $100 bn balance sheet. </li></ul></ul></ul><ul><ul><ul><li>Economies of scope non-existent (span of control and lack of focus problems). </li></ul></ul></ul><ul><ul><li>In the short term, fewer and larger banks </li></ul></ul><ul><ul><li>In the medium term, more and smaller banks </li></ul></ul>
  13. 13. <ul><li>Classic example of market discipline undermined by political economy considerations </li></ul><ul><li>Too big to fail is a financial stability myth, but a powerful political economy reality </li></ul><ul><li>Orderly resolutions of bankruptcy/defaults/insolvencies of even the largest banks and financial institutions are easy </li></ul>
  14. 14. <ul><li>Requires </li></ul><ul><ul><li>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 . </li></ul></ul><ul><ul><li>Ability to ring-fence payment, settlement, clearing, custodial activities of banks (& possibly counterparties of banks also). </li></ul></ul><ul><ul><li>(Possibly) counterparties (CDS holders) senior to unsecured creditors </li></ul></ul><ul><ul><li>Clarity on the exact seniority ordering of all claimants </li></ul></ul><ul><ul><li>Political strength to resist pressure from unsecured creditors (pension funds, insurance companies, other banks) and other lobbyists </li></ul></ul>
  15. 15. Good Bank -Bad Bank Deconstruction of RBS Group end-2008 Balance Sheet (following the Bulow-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 & other non-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%
  16. 16. <ul><ul><li>Central banks, Treasuries and regulators/supervisors are national </li></ul></ul><ul><ul><li>No more cross-border branches regulated & supervised by home country (Icesave) </li></ul></ul><ul><ul><ul><li>EU principle of mutual recognition, single passport RIP </li></ul></ul></ul><ul><ul><li>Only independently capitalised subsidiaries, with own assets & liquidity; managed at arm’s length from parent & regulated & supervised by host country </li></ul></ul><ul><ul><li>Home country Treasury cannot be expected to bail out foreign subsidiaries of national banks </li></ul></ul>Repatriation of cross-border banking
  17. 17. <ul><li>Special problems of the EMU </li></ul><ul><ul><li>One central bank for 16 countries </li></ul></ul><ul><ul><li>No fiscal Europe </li></ul></ul><ul><ul><li>No European regulator-supervisor for border-crossing systemically important financial institutions. </li></ul></ul><ul><ul><li>Because of 2., credit easing by ECB/Eurosystem problematic: who recapitalises the ECB? </li></ul></ul>
  18. 18. <ul><li>Central bank’s conventional equity, W, need not be positive, but its comprehensive net worth, </li></ul><ul><li>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. </li></ul><ul><li>Restoring solvency even through seigniorage may be impossible if the exposure of the central bank is to foreign currency assets or index-linked assets. </li></ul><ul><li>In that case only a low or negative realisation of T can restore central bank solvency </li></ul>
  19. 19. <ul><li>ECB itself small and irrelevant </li></ul><ul><li>Eurosystem (ECB + 16 Euro Area NCBs) large and relevant, but not fully integrated </li></ul><ul><li>NCBs share losses incurred as a result of Eurosystem monetary operations, liquidity operations and credit-enhancing operations </li></ul><ul><li>NCBs do not share losses incurred by NCB acting as quasi-fiscal agent for national Treasury </li></ul><ul><li>NCBs do no pool capital. </li></ul>
  20. 20. Eurosystem Assets, 08/-5/2009 Assets (EUR millions) 1 Gold and gold receivables 240,817 2 Claims on non-euro area residents denominated in foreign currency 159,299 3 Claims on euro area residents denominated in foreign currency 123,101 4 Claims on non-euro area residents denominated in euro 21,359 5 Lending 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 26,453 7 Securities of euro area residents denominated in euro 292,405 8 General government debt denominated in euro 36,790 9 Other assets 241,523 Total assets 1,795,099
  21. 21. Eurosystem Liabilities, 08-05-2009 Liabilities (EUR millions) 1 Banknotes in circulation 759,502 2 Liabilities 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 159,644 11 Revaluation accounts 202,952 12 Capital and reserves 72,840 Total liabilities 1,795,099
  22. 22. <ul><li>Consolidated financial statement of the Eurosystem as at 8 May 2009 : </li></ul><ul><ul><li>Bad news: Eurosystem has only €74 bn of capital and reserves & €1,795 bn worth of assets, i.e. 24.6 times leverage </li></ul></ul><ul><ul><li>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) </li></ul></ul>
  23. 23. <ul><li>With 4 % trend nominal GDP growth a reasonable seigniorage benchmark is 0.33% of GDP each year (currently €32bn)( required reserves are remunerated). </li></ul><ul><li>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. </li></ul><ul><li>Safe but beware: </li></ul><ul><ul><li>growth of balance sheet of Eurosystem </li></ul></ul><ul><ul><li>Financial development and crime-fighting could reduce seigniorage revenue </li></ul></ul>
  24. 24. <ul><li>Is the ECB too independent to play a Euro-Area- or EU-wide role as regards macro-prudential supervision & regulation? </li></ul><ul><li>ECB may have to chose: independence and irrelevance or less independence and greater relevance. </li></ul>