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European banking system needs redesign to prevent another crisis

The new government will take office on March 9 (Ash Wednesday, as it happens) and will face immediately the task of forging a response to the Franco-German plan to resolve the Eurozone crisis unveiled at the Brussels summit last Friday week.

It calls, as these documents invariably do, for greater integration of European economic policy. The main proposals are for closer harmonisation of tax and spending policies, including constitutional limits on borrowing, a common approach to corporation tax, higher retirement ages in state pension systems and an end to wage indexation. The theme is a more competitive Europe with better fiscal discipline.

The plan has already received a frosty welcome. Everyone is in favour of better fiscal discipline, preferably at some distant future date, but states which have wage indexation want to keep it, higher retirement ages are unpopular in countries where the current figure is low and member states with attractive rates of corporation tax (Ireland is not the only one) want to keep them. There is a far better reason to resist the proposals, however. Europe is facing a serious financial crisis and the Franco-German programme looks like another integrationist push rather than a serious attempt either to resolve the continuing crisis or to prevent the next one.

The crisis in Europe, with the possible exception of what has happened in Greece, does not have its origins in loose budgetary policy. Its origins lie in a crisis of overleveraged banks making foolish lending decisions. Banks differ enormously in life but are indistinguishable in death: they go bust because they make bad loans and bad investments. Prudent banks, with cautious balance sheets and borrowers able to repay, do not go bust. In Europe, the introduction of the new common currency in 1999 was followed by a period of excess, not in loose fiscal policy but in the careless expansion of bank balance sheets through the accumulation of large liabilities to bondholders and wholesale lenders, in addition to the normal reliance on retail deposits.

These growing resources were deployed in the acquisition of dud assets. An extreme example was Anglo Irish Bank, which appears to have written off about 45 percent (and counting) of the amount it lent. In Ireland the dud assets were property and mortgage loans in the main. Something similar but on a smaller scale happened in Spain and in the United Kingdom. The dud assets acquired in France, Germany and other continental countries included exotic derivatives of mortgage loans in the United States as well as bonds issued by dodgy banks in places like Ireland.

The result of the banking crash has been a descent into unsustainable budget deficit in many countries. Those which had big government debts to begin with (Greece), or which allowed a greater banking bust to emerge (Ireland), have ended up in the most trouble. But the problem is general and in Germany, for example, the budget rules of the Eurozone were broken earlier than in countries like Ireland and there is widespread nervousness about the true condition of large parts of the German banking system.

Any plan from the EU Commission, the European Central Bank or the traditional political engine in the shape of Franco-German initiatives needs to pass one or both of the following tests: does the plan clean up the crisis which has arisen, and does it help to avoid a recurrence?

The latest Franco-German plan does not pass the first test, since it studiously avoids addressing the nature of the crisis. The European economies have not been experiencing the worst recession since the Second World War because the retirement age is too low, or because there are national differences in corporation tax rates. Ireland is not in an IMF bailout because the budget deficit, in the years before the crisis, was outside the Eurozone parameters. There was exemplary compliance with the fiscal policy rules and all boxes were ticked, up until 2007, in Ireland and in most Eurozone countries. This is a banking crisis and it remains unresolved three years after the bubble began to burst.

Resolving the crisis which has arisen in the Eurozone requires three simple steps. These are: stress-test the banks properly, in a manner which has credibility in the markets; distribute the losses, and re-capitalise whatever banks are deemed necessary for the long haul. Preventing the next crisis requires a redesign of the Eurosystem, including credible bank supervision and the avoidance of moral hazard, that is, the compensation of imprudent risk-taking.

The stress tests attempted by the European Central Bank last July were not believed. One of the banks which passed was AIB, which has since, to all intents and purposes, gone under. For a central bank dealing with a crisis of confidence in the solvency of its banks to deliver a non-credible stress-test is worse than doing nothing. A new set of stress-tests, under ECB supervision, is currently being conducted and the results are expected in April. If they give a clean bill of health to, for example, every bank covered, or if the tests conveniently exclude banks which are dodgy, the exercise is another waste of time and will fail again. It is extraordinary that the European banking system is still being stress-tested three years after the failure of Bear Sterns signaled the onset of the international financial crisis.

Adequate stress-tests should identify the banks which need recapitalisation, once and for all. If private equity is not available, which will not be the case for the basket-cases, the gap must be made up by taxpayers or through hair-cutting bondholders foolish or unlucky enough to have invested in these banks. To expect taxpayers alone, and only those in the countries unlucky enough to have hosted the mis-supervised banks, risks sovereign default in these countries, of which Ireland is the prime example.

Barry Eichengreen of the University of California at Berkeley summarises the position thus: "But one item is prominently absent from the new agenda: financial regulation. Aside from Greece, whose problems reflect years of fiscal profligacy, the euro crisis is fundamentally a banking crisis. Although the European Union activated three new 'financial regulators' for banking, securities markets, and the insurance industry on January 1, these new entities have limited powers. They mainly act to coordinate the periodic meetings of national regulators.

"In a monetary union, the idea of leaving financial regulation in the hands of individual countries is madness. Given the interconnectedness of national banking markets in the European Union, the actions taken by any one national regulator -- say, Ireland's permitting its banks to borrow huge volumes of foreign money to engage in all manner of reckless property speculation -- can have serious repercussions for the rest of the European Union. Why Friday's summit wasn't used to propose the creation of a single powerful EU or euro-area bank regulator is a mystery. If one didn't know better, one might suggest that Germany, whose banks are exceptionally highly leveraged and poorly capitalised, was cowed by certain special interests."

There is a practical objection to a Europe-wide bank resolution: it would finally address the burden-sharing issue which French and German politicians wish to avoid. The ECB, whose policy throughout the crisis to date has been driven by no-bank-must-fail mantra and the protection of bondholders, needs a thorough redesign if another crisis is to be avoided. The Franco-German plan is also silent on this crucial issue.

Aside from employees of the European Central Bank, prominent economists have been virtually unanimous these last few months in dissenting from the non-policy being pursued. Bloomberg quoted another well-respected practitioner of the dismal science during the week in the following terms: "Senior bondholders of European banks should take a haircut on their investments instead of struggling banks being supported by taxpayer bailouts," Citigroup's chief economist, Willem Buiter, said.

"As soon as the end of this year, all the European zombie banks could be restored to health or put out of business by making senior bondholders pay instead of the taxpayer," Mr Buiter said, adding that state support for failing financial institutions should be removed as soon as possible.

The risk of another European banking crisis down the road can be minimised only through the redesign of the ECB and the Eurosystem. The redesign should involve the centralisation of bank supervision, which in an integrated banking market cannot safely be delegated to small countries with limited administrative resources. This logically raises the question of abolishing the national central banks altogether. In seeking a better deal for Ireland in the resolution of the European banking crisis, Irish politicians should not be shy about urging a better deal for Europe; a deal which at least addresses the unresolved current crisis and the prevention of the next one.

Colm McCarthy lectures in Economics at University College Dublin. He has headed an expert group examining State assets and chaired the Special Group on Public Service Numbers and Expenditure Programmes, aka An Bord Snip Nua

Sunday Independent