Some Arguments against a European Fund to Bail out Troubled Banks
University of Amsterdam, CEPR and CESifo
As the details of Paulson’s rescue plan for troubled U.S. banks are being negotiated, some experts are now calling for Europe to set up a similar fund for helping banks that have become the victims of the credit crisis. For example, this week a former Board member of ABN-AMRO (a bank that was recently taken over by a consortium of RBS, Banco Santander and Fortis) argued that the EU should set up a fund of roughly 600 billion euro’s to buy up bad loans from the banking sector. Obviously, the chances that a major European bank may fail have increased substantially in recent months. One of the most vulnerable banks now is Fortis, a Belgian-Dutch bank, which got into trouble as a result of a combination of the credit crisis and the need to finance the takeover of their part of ABN-AMRO in an unfavourable capital market. While a European rescue fund may provide short-run relief and prevent major banks from bankruptcy, it would a bad idea.
First, financial supervision has been a national responsibility so far. Supervisory tightness differs across countries and some banks may get into trouble as a result of supervision that is lax relative to that in other countries. While lax supervision provides domestic institutions with an advantage in good times, it leads to a worse financial situation in bad times. It would be unfair if all EU citizens would need to pay for the consequences of weak supervision in one of the member states. A European rescue fund for financial institutions would only make sense when the responsibility for financial supervision has been shifted to the EU level and uniform supervisory rules are applied to institutions from all over the area. Second, there is no need to organize bail-outs at the European level. The public money that would be needed for a bail out can be put up by the taxpayers of the country where the bank has its head-quarters or its operations. Also, there may be a possibility to involve one or more other banks from the same country to help finance a bail-out. Allegedly, Rabobank (another Dutch bank, which has hardly been affected by the crisis) was approached by the Dutch central bank to keep its credit lines to Fortis open. Obviously, if other banks are involved they expect something in return and in the end taxpayers’ money must be involved. However, what arises as a problem in one country or a few countries should be solved with the instruments and at the cost of those countries. Of course, national authorities may argue that they do not have the resources to help their own bank out of its troubles. Knowing that other countries fear the spill-over effects of a domestic bank failure, they may try to force foreign governments into co-financing a bail-out. Nevertheless, the local consequences of the failure of a domestic bank would generally be most severe, implying that the strongest incentive to deal with the troubled bank lies at home. Third, and this is an objection not only to a European fund but to rescue plans in general, they are likely to produce moral hazard in the longer run. Once the current mess has been sorted out and banks have been recapitalized and relieved of their bad loans, the process of reckless lending and mortgage provision starts all over again in the expectation that a few years from now governments stand again ready to bail them out. Besides this, most CEOs remain at the top for only a few years in any case, while their salaries (including bonuses) depend very strongly on the performance of their institution’s shares. The high likelihood that trouble occurs only after their departure provides them with an incentive to take undue risks. A final general objection to any rescue plan is that it is prone to fraud (or at least unintended practices). For example, banks may exaggerate the extent of their problems to extract more rescue money or they may be able to shed more bad loans at prices above market value than would be needed to stay afloat.