Keep Banks Out of Greek Aid Package

Notwithstanding the vagueness of the official EU statement (February 11) on Greece, rumours on how a Greek rescue package might be designed continue to pop up in the news. One of the scenarios is to channel aid through the financial system. According to EU sources, a possible purchase of Greek government bonds by a German state-owned development bank has been discussed. Such a solution has obvious attractions to politicians. It doesn’t directly involve taxpayer’s money and it may provide a way around the no-bailout clause of the Maastricht Treaty. Yet fixing a sovereign debt problem with banks is a bad idea. It is also not what EU leaders had in mind when they drafted the Maastricht Treaty.

The entanglement between European governments and their financial institutions is already much too strong as it is. Public debt is a favourite investment of many European banks. On average, euro-area banks’ holdings of public debt (mostly from their own government) are larger than their capital. At the end of January 2010, lending to general government (both loans and securities) by euro area MFI’s amounted to € 2510 bln, against € 1917 bln in capital and reserves. This fact provided a major justification for the Stability and Growth Pact (SGP), as sovereign debt crises could undermine the stability of the European financial system. The SGP aimed at lowering the likelihood of a debt crisis by maintaining fiscal discipline. The Greek crisis makes it abundantly clear that this strategy has failed. Reform of the SGP may or may not reduce the likelihood of future debt crises. In the meantime it makes sense to find solutions to limit the damage to the financial system if such crises were again to occur. In this regard, aiding Greece through banks would be a step in the wrong direction.

A step in the opposite and more prudent direction would be to put a limit on the amount of sovereign debt that banks can take on their balance sheets. The likelihood that a sovereign debt crisis threatens the solvency of banks can be easily and quickly reduced through proper banking regulation. A starting point is to extend the so-called large exposure directive, which states that banks should not lend more than 25% of their capital to a single private borrower, to government debt. In addition, the directive should also apply to banks’ trading books and the percentage of capital exposed to a single counterparty could be further reduced.

Abolishing the exemption from the large exposure directive which governments currently enjoy would put an end to the positive discrimination in favour of public debt. This public privilege is a legacy of the pre-EMU era, when governments still had command over money creation and thus an unchallenged ability to pay off domestic currency debt whatever happened in the bond market. The raison d’être of such discriminatory regulation disappeared once EMU removed the privilege of money creation from national governments. Though euro area governments have retained the right to impose taxes other than the inflation tax, this is no guarantee for default-free public debt. In the past, a state’s power to tax did not prevent defaults on foreign currency debt in many countries. When money creation does not offer an easy way out, politicians can arrive in a situation where default on public debt is easier than raising taxes or cutting spending. This shouldn’t be too hard to imagine when Greeks take to the streets to protest against reform. Credit rating agencies have since long recognized the change in the risk profile of public debt. At the start of EMU, six founding members lost their standard AAA rating for domestic currency debt.

The government exemption from the large exposure directive also goes against the spirit (and maybe even against the letter) of the prohibition on privileged access for the public sector to financial institutions, which is laid down in article 102 (ex 104A) of the Maastricht Treaty. Article 102 reads: “any measure, not based on prudential considerations, establishing privileged access by community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States to financial institutions shall be prohibited.” At the end of January 2010, Greek banks held €46 bln in public sector assets (mostly Greek), which is larger than the size of their capital and reserves (€39 bln). It is hard to argue why the Greek government is exempted from the large exposure directive, when higher-quality private creditors must comply. This is a privilege indeed. And one can hardly argue that this privilege can be based on prudential considerations.

For the sake of financial stability, banks should be protected from attempts by governments to use bank funding when bond markets dry up. This is the reason why article 102 has been included in the Maastricht Treaty. Limiting and diversifying public debt holdings of banks would bring banking regulation in line with article 102 and increase banks’ abilities to withstand disruptions in the market for sovereign debt. Increased diversification of the credit exposures of banks to the public sector would thus promote the stability of the euro-area financial system. It would also prevent Europe from being held hostage by a profligate government, whose negotiating power increases with the amount of its public debt that has infected Europe’s banking system. EMU has altered the risk profile of euro-area public debt. Recognition of this fact in banking regulation would provide a welcome strengthening of the credibility of the no-bailout clause.

One Response to "Keep Banks Out of Greek Aid Package"

  1. Guest   March 2, 2010 at 6:08 am

    Living in Greece and knowing how Greek politicans love obfuscation as well as how the EU culture of corruption works, I could not agree more with your views!