Banks are fragile institutions and failures of individual banks, and of whole banking systems, are a regular occurrence around the world. Banks hold assets as much as 20 times their free-risk capital, the amount they can afford to lose. Through lax oversight and the use of off-balance sheet vehicles, many European banks were allowed to hold even less true capital than appeared the case during the recent crisis.
Their principal assets, particularly loans to customers, cannot readily be realised while their deposits can flow away rapidly. A bank forced to write off even one loan in 20 will have no free capital and depositors will flee. If it wishes to restore liquidity, it needs to shrink its balance sheet by large amounts rapidly, restricting credit and exacerbating the decline in the collateral values backing its surviving loans. A banking system with thin capital and illiquid assets, financed with short-term deposits, is an unexploded bomb.
Bank failures can be minor, affecting just one small and poorly managed bank, or they can be systemic, threatening the entire economy. Consequently banks are licensed, regulated and supervised through central banks or specialist financial regulators, whose role is two-fold. The first task is to prevent banking crises, the second to resolve them quickly, and with minimum damage to the rest of the economy.
On both counts, the performance of the European Central Bank through the crisis has been unimpressive. Regulation and supervision were delegated from the outset to national bodies in each eurozone member, with catastrophic results in Ireland and substantial failures also in Germany, Spain and elsewhere.
Oversight of this delegated system at the eurozone level was complacent. While the trigger was the subprime mortgage meltdown in the United States, the cause of this European banking crisis was the fragility of the European banking system itself, in particular the combination of thin capital, weak liquidity and the contagion risk created by large capital flows.
National governments have been left to their own devices in dealing with failing banks and there was no central contingency plan aside from liquidity provision. Resolution policy as enunciated by the ECB and the EU Commission consists of blaming national regulators in debtor (but not creditor) countries for the European banking crisis and allocating the costs of resolution to the taxpayers of debtor countries only.
The pretence is maintained that regulatory failures in creditor countries did not contribute, provided their access to the sovereign debt market remains intact. The costs of European bank resolution are to be borne through the retrospective compensation of imprudent and poorly supervised lenders by taxpayers in countries in distress and unable to borrow. Europe has muddled its way to a bizarre transfer union, with taxpayers in distressed eurozone members transferring billions to compensate bondholders in more fortunate jurisdictions, a rather different transfer union from the one portrayed in the German populist press.
The protection of imprudent lenders from the consequences of their actions creates 'moral hazard', a fancy term for the risk that they will repeat the performance, having paid no price for past carelessness. Taxpayers in debtor countries, foolish enough to have elected incompetent governments unwilling to supervise banks properly, must pay up. In a nutshell, there must be no risk of moral hazard for voters-cum-taxpayers in countries like Ireland, but moral hazard for imprudent lenders in countries like Germany is just fine.
This tortuous line of reasoning lies behind the 'stick-to-the-programme' sermons from European politicians and officials to which the Irish electorate is treated on a daily basis. All will be well, apparently, if the terms of the IMF/EU programme are adhered to, which means successful re-entry to the bond market at affordable interest rates by autumn 2012. This is to be attained by a country facing an adverse credit spread of six per cent against Germany in the secondary bond market. A further upbeat homily along these lines was offered last Wednesday in an article in the Financial Times by ECB executive board member Lorenzo Bini Smaghi.
His message is exclusive reliance on fiscal tightening in Ireland with no default on bank or sovereign debt. The sums will add up and all will be well. There must be no moral hazard for voters and no backsliding on transfers to imprudent lenders to insolvent Irish banks. On Thursday the tireless Mr Bini Smaghi recycled his message for a Greek audience. Reuters reported thus: "Any move by Greece to restructure its debt would have catastrophic effects, ruining its banks and crippling its economy.
"According to our analysis, a debt restructuring would result in the failure of a large part of Greece's banking system," Mr Bini Smaghi told Italian business daily Il Sole 24 Ore. "The Greek economy would be on its knees, with devastating effects on social cohesion and the maintenance of democracy in that country," he was quoted as saying. "Ultimately it's up to Greece to decide the way forward, given that it will suffer the worst consequences."
ECB colleague Juergen Stark is supportive. He spoke to the Irish Independent last Thursday and expressed bemusement that the ECB was being "blamed" for Ireland's predicament when financial regulation was a "matter for national authorities" and financial stability was a "matter for national governments".
Mr Stark claimed that the ECB drew attention to Ireland's economic imbalances and "expressed warnings" repeatedly at EU meetings "from 2005 or 2006 at the latest" and he rubbished the idea that the €150bn loaned by the ECB to the banks could be restructured. "This has to be paid back," he said.
If Mr Stark has in his possession minutes of EU meetings at which these warnings were given, it would be a public service to release them. There is no trace of alarm at the conduct of bank regulation in Ireland in the public record from those years.
Remarkably (or fortunately) the ECB does not speak with one voice on these questions. The Irish Times reported a very different perspective on April 7 last: "'Holders of Irish bank bonds should take losses instead of the Irish Government footing the bill for their bailout,' European Central Bank governing council member Axel Weber said today. Mr Weber, who is stepping down from the German Bundesbank at the end of April, said it was a big mistake for governments to make taxpayers liable for all bank risks. 'To save a country's banking system, it is not necessary to write a blank cheque for the total balance sheet of the banking system,' Mr Weber said.
"'In Ireland, the question is whether the banking sector has to be saved as a whole,' he added. 'Would it not be a better route to isolate deposits, to minimise losses to Irish taxpayers and to find a complete solution . . . with private sector participation instead of buying them out.'"
Mr Weber echoes the consistent editorial position of the Financial Times, the Wall Street Journal and the Economist magazine among others. More significantly, the IMF's managing director, Dominiq-ue Strauss-Kahn, criticised what he described as the "piecemeal" approach being adopted in Europe. Numerous German economists and politicians have also drawn conclusions critical of current policy.
Thus former German foreign minister Joschka Fischer and economist Henrik Enderlein as reported in the Irish Times on April 7: "Mr Fischer said Berlin was being disingenuous in factoring out the culpability of German banks -- particularly state-owned institutions -- in the Irish financial crisis.
"'In the backrooms in Dublin it was our (state-owned) Landesbanks earning all the money to the delight of our state governments of all political persuasions. No one tells the people here that part,' he said. 'Ireland could have gotten away well if Brian Cowen had said, "we will save Irish banks but English Banks and German banks are not our problem.'"
Economics professor Henrik Enderlein went further, saying Dr Merkel's government was "hushing up on purpose" German involvement. "It's clear German state-owned banks are a key issue in the (Irish) problem," he said. "But if this got out into the open we'd have a problem with five state governors and if the German federal system needed to become part of solving European difficulties, then we would have a real problem."
The Government needs to be more forceful in drawing European attention to the punitive stance being taken to the financing of bank resolution by the EU Commission and the ECB.
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.