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As Europe’s Banks Falter, Is There A Risk To The Eurozone?

“We do not have a federal budget, so the idea that we could do the same as what is done on the other side of the Atlantic doesn’t fit with the political structure of Europe,”

Jean-Claude Trichet, commenting last week on the Eupean “summit” in Paris last Saturday

“If you concentrate on California or Florida, it is not at all like Massachusetts or Alaska……It is the same in our case and we have to make a judgment what is good for the full body of the 320 million people” in the euro area.”

Jean Claude Trichet in an interview with Ireland’s RTE radio last July, following the controversial decision to raise ECB interest rates to 4.25%

“Europe gives up on a joint rescue plan against the crisis,” since the EU “lacks the necessary institutions to respond as the United States has done”.

Spain’s El Pais yesterday (Sunday 5 October)

For Europe, this is more than just a banking crisis. Unlike in the US, it could develop into a monetary regime crisis. A systemic banking crisis is one of those few conceivable shocks with the potential to destroy Europe’s monetary union. The enthusiasm for creating a single currency was unfortunately never matched by an equal enthusiasm to provide the correspondingly effective institutions to handle financial crises. Most of the time, it does not matter. But it matters now. For that reason alone, the case for a European rescue plan is overwhelming.

Wolfgang Munchau, The Financial Times, Monday 6 October 2008

The euro had its biggest one-day drop against the yen in seven years this morning as the deepening credit crisis prompted European governments to pledge bailouts for troubled banks while stopping short of coordinated action. The 15-nation currency declined to a 14-month low against the dollar – hitting $1.3598 at 8:52 a.m. in London – and to its weakest in two years versus the yen after European leaders meeting this weekend avoided announcing any plan that would mirror the U.S.’s $700 billion bailout. And the reason for the euro’s fall is clear, the ability of the eurozone countries to apply a concerted startegy to address the problems in the banking and financial system has been called into question, and nowhere is the huge gap between the currency’s ambition and its political architecture so evident as it is in the above two quotes from Jean Claude Trichet. When push comes to shove, the US Treasury, as we have seen last week, does not concentrate on the needs of Florida or Massachusetts, but on those of the entire United States, and who, may we ask is in a position to concentrate at this point on the financing needs of the whole 15 member eurozone-area, since trying to manage economies which are one organic whole by splitting them analytically into monetary and fiscal entitites simply isn’t going to work, and it never was. Let me expain.

The current pressure on the euro is more the result of liquidity and solvency problems in the banking sector (and perceived institutional deficiencies when it comes to being able to address these) than it is a response to the growing weaknesses in the real economies eurozone real economies, which, as I have already recently argued here, probably mean that the zone as a whole has now entered the first recession in its short history.

When it comes to the liquidity and solvency issues, I do think we can already identify some clear trends, since we can see that in those European countries which had substantial housing booms – the UK, Ireland, Greece, Spain and Denmark – the bank exposure is to the drop in the value of the underlying assets (the houses, or the land, or the malls, or the office blocks) and to the defaults in payments (either by builders or by companies, or by homeowners) which have their origin in the impact of the mortgage seize-up on the real economy (rising unemployment, declining bonus payments, falling retail sales and industrial output, etc), whereas in non-housing boom countries (lead by Germany, Italy, Sweden and Austria) the exposure is to lending which was made to banks in the boom countries – first and foremost in the United States, but also in the UK and Ireland (see Germany’s Hypo and it’s Irish subsidiary Depfa) and, of course (and the largest slice of this is yet to come) in Eastern Europe (lead by banks in Sweden, Austria and Italy).

The other key thread is whether or not the institution in question lent against deposits, or depended on the wholesale money markets for funding. The banks – lead in this case by the Spanish armada – who were most dependent on external borrowing are now evidently those who have (or are about to have) the biggest problems.

In theory, the 27-nation EU structure should offer a ready means of coordinating policy. But while the EU has unified laws on areas like trade and labour standards (and in the near future on immigration) more broad-reaching policy harmonisation (such as fiscal coordination) has long been resisted, and the recent sorry attempts to introduce a basic constitution provide clear evidence of the difficulties which lie ahead. The EU has no institutional equivalent of the US Treasury, which is why all the initiatives which we have seen to date – for all the European “feel” about them – have been either ad hoc bi- or tri- lateral arrangements.

US National Bureau of Economic Research head Marty Feldstein has long been on record as pointing out that the greatest weakness in the eurosystem architecture from the start has been the absence of a common fiscal system, and the inability to correct the problems caused by deficits in one country drawing on surpluses in another. When he first raised these issues Feldstein was undoubtedly thinking about the possibility of asymetric recessionary processes, and the need to coordinate fiscal stimulus – and I doubt was thinking about a problem of the severity of the one we now face – but in the longer run he has been proved right, this sort of problem was always going to arise at some point or another. As Jean Claude Trichet is now finding out, in macroeconomic management terms you simply cannot have your cake and eat it.

My basic point is a simple one: the European institutional structure with a centralized monetary policy but decentralized fiscal policies creates a very strong bias toward large chronic fiscal deficits and rising ratios of debt to GDP. An effective political agreement among the Eurozone countries is needed to prevent those deficits.

Without either discretionary monetary policy or an automatic cyclical adjustment of interest rates or of the exchange rate, a country can stimulate aggregate demand only by fiscal policy. While a fiscal policy can in principle take the form of a revenue neutral change in fiscal incentives – e.g., an investment tax credit offset by a temporary rise in the corporate income tax rate – the usual fiscal response to an economic downturn is a tax cut that increases the budget deficit. Moreover, deficitexpanding fiscal policy has greater potency with the interest rate and exchange rate essentially fixed than it would if the country had its own currency.

There is also a greater need in Europe than in the United States to use discretionary fiscal policy to respond to an economic downturn in a “local” area – i.e., in a European country or an American state. This reflects both fundamental labor market differences between Europe and the US and differences between the two fiscal systems. By fundamental labor market differences I mean the much greater geographic mobility and wage flexibility in the US than in Europe. A sharp decline in demand for the products of Massachusetts, my own state, some years ago led to a relative decline in the Massachusetts labor force (more out-migration and less in-migration) and to a decline in the relative wage of Massachusetts workers. The European labor force is much less mobile (because of differences in language and culture and a general reluctance to move even within countries) and wages are much less flexible.

The contrast between the centralized fiscal system in the United States and the decentralized fiscal system in Europe is also very important in this context. A decline of economic activity in a single US state automatically causes a substantial decline in the flow of taxes to Washington from residents and businesses in that state and an increase in transfer payments from Washington. The magnitude is roughly equal to 40 percent of the local decline in GDP. This net fiscal swing constitutes a significant external fiscal stimulus to the local economy. In contrast, with the decentralized European fiscal system, a fall of GDP in any country causes a contraction in tax revenue in that country but very little net transfer from outside. In short, the combination of a centralized monetary policy and a decentralized fiscal structure in Europe increases the need for and the effectiveness of countercyclical fiscal policy.

Marty Feldstein, The Euro And The Stability Pact

Unicredit Sinks Like A Stone

The shares of Italy’s second largest bank, UniCredit SpA, fell as much as 16 percent at one point in Milan trading this morning, hitting 2.59 euros and taking the shares back into the region of the 11-year low of 2.55 euros registered on Sept. 30. The drop follows an emergency capital boost of 6.6 billion euros decided on in an emergency board meeting held yesterday afternoon, where the exceptional measures decided on to raise the cash included paying this years dividends in company shares.

The “shares for dividends decision” forms part of a battery of measures which includes significant cost cuts and asset sales in order to try to guarantee that the core Tier I capital ratio, a measure of the banks’ financial strength, rises to 6.7 percent by the end of the year, from 5.7 percent now. A core Tier I of 6 percent or higher is generally considered an adequate minimum for banks.

Trading in the shares was temporarily suspended, and after the reopening they bounced back to 3.0 euros, leaving them down on the day by 2.7 percent, at 12:47 p.m. local time. The problems at Unicredit lead the whole Italian banking sector down, and Italy’s S&P/MIB Index declined the most in more than seven years this morning, losing 1,435, or 5.5 percent, to 24,476.

But what if this had been a bank with a name of a large European country, or an acronym that refers to a large European city, banks that are simultaneously too big to fail and too big to save? I shudder to think what would happen when Silvio Berlusconi, Angela Merkel, Lech Kaczynski and the next Austrian leader have to meet to discuss the future of a large cross-border European bank.

Wolfgang Munchau, The Financial Times, Monday 6 October 2008

UniCredit SpA, is, as I say, Italy’s second biggest bank and it is also owner of Germany’s HVB Group. The current crisis started last week when shares fell more than 24 percent in three days as increasingly looked like the bank was going to need to raise money to strengthen its finances. One of the issues was concern that UniCredit may be asked to help in the bailout of Germany’s Hypo Real Estate Holding, a development which could have negative consequences for Unicredit’s capital position. Hypo Real Estate was in fact spun off from HVB Group in 2003.

But Unicredit is also exposed due to the extent of its lending in Eastern Europe – which are estimated to amount to one quarter of its total operations. Unicredit is deeply involved across Eastern Europe via its ownership of HVB group, as well as via it’s ownership of Bank Austria Creditanstalt. Among other issues Unicredit exposed in the Baltics, since on September 1, 2007 ASUniCredit Bank Estonian took over the business of HVB Bank Tallinn. But the extent of Unicredit East European lending is much more extensive than this, and with property markets in one EU10 country after another now likely to “correct” the problem is likely to become much larger than merely the German Hypo Real Estate one.

Fitch Ratings last Thursday downgraded the Outlook on UniCredit to Negative from Positive. At the same time Fitch changed the Outlook on Unicredit’s main subsidiaries – Germany-based Bayerische Hypo- und Vereinsbank AG (HVB) and Austria-based Bank Austria Creditanstalt AG – to Negative from Positive. Fitch stressed as reasons for the downgrade the poor macroeconomic prospects in Italy and Germany and in particular the less benign outlook for some central and eastern European markets. Fitch also regards UC’s current capitalisation (end-H108 Basel 1 core Tier 1 ratio of 5.55%) as tight in relation to its risks especially given thatconditions in the wholesale funding market remain “extremely challenging”.

So the question is, is Unicredit too big to fail, or too big to save?

Government Guarantees For Deposits

One popular way of handling the present pressure the banks are under has been to give guarantees to depositors. The Irish were the first to do this, and they have been subsequently followed by The Greeks, the Danes, the Swedes and now the Germans. Up to this point the Italian and Spanish authorities have been notably silent on this matter, and the reason why is not hard to imagine.

Basically Ireland may have quite large problems, but it can, being a small country, “piggy back” from the United Kingdom, by attracting deposits from their larger neighbour. An analysis carried out at Credit Suisse has shown how movements of cash by relatively few depositors may have a bigger effect in countries which a significant proportion of deposits is concentrated among relatively small percentage of the customer base, as is the case in the U.K. (for example) where 4 percent of the banks’ customers hold 45 percent of the deposit base.

But where can the Spanish banks look for this kind of support. It is their very size and the size of the problem they have that makes for the problem. The vaguely-insinuated plan which was “nearly – but never actually – proposed” at last Saturday’s Paris meeting was for a fund of 300 billion euros. But Germany’s Die Welt reported over the weekend that Hypo Real Estate alone will need 20 billion euros by the end of next week and 50 billion euros by the end of the year, to be followed by as much as 100 billion euros by the end of 2009. And this is just one “quasi bank”.

Spain’s needs are likely to be much larger – I personally have estimated between 300 and 500 billion euros for Spain alone, between toxic financial instruments and non-performing loans from builders and other corporates. And what about Unicredit. We have no real idea how much funding Unicredit may need.

And so we need to go back to Marty Feldman, and to think about the budget deficits issue. In general European governments have little room for large scale fiscal support either on the annual deficit side, or on the debt to GDP ratio one. Given the ageing related commitments (pensions, health costs) which are looming (in particular after 2012) for some key European governments (especially Germany and Italy) it is hard to accept that there is much headroom to play around with, and remember all this government support for banks has to be funded somehow – either out of revenue, or by raising debt. In particular, if certain of the EU national governments move back on the commitment to balance the budgets by 2011 then we will only start to shift from banking instition downgrades to sovereign rating ones. This is why I titled this post the way I did. If either Italian government finances, or the Spanish banking system, are simply allowed to unwind for lack of visible support, then the Eurozone itself which most definitely be put at risk. The visible lack of any coherent strategy or plan could not be considered one of those cases of some people somewhere fiddling with their thumbs while Rome and Madrid were burning, now could it?

Originally published at A Fistful of Euros on Oct 6, 2008 and reproduced here with the author’s permission.

One Response to “As Europe’s Banks Falter, Is There A Risk To The Eurozone?”

GuestOctober 7th, 2008 at 8:14 am

The comparisons to the US situation are simply scary, Europe is not a United States – we are separate and sovereign member states governed primarily by our own self-interest first, intergovernmentalism second, and supra-nationalism NEVER! These crazy federalists like Jean Claude Trichet are leading us into a disaster. The Euro is a disgrace. It has only gained some inkling of relevance given the massive undervaluing of the US Dollar. Before that it had lost over 20% of its value in the first two years of existence. Added to that, Dutch government undervaluing of the Guilder to meet entry conditions (at the cost to Dutch savers) contrasted with flagrant Italian, German and French rulebreaking makes the UK and Danish opt out seem like a glorious decision!!! The sooner this horrible contrived federalist utopian dream is realised as the nightmare it really is, the better for all Europeans!