An overhaul of Europe's pre-crash banking system is long overdue
Bank managers still have little to stop them incurring risks at taxpayers' expense.
Taxpayers will not get saddled with large public debts resulting from the rescue of failed banks unless three things happen first. The banks need to make losses large enough to exhaust their spare capital. The regulators need to do nothing to stop them incurring these losses. Finally the government needs to catch the falling knife, in order to protect the creditors of the banks.
Banking is a risky business for lots of reasons but the main problem is called leverage. Bank assets, mostly loans to customers, are never risk-free and even prudent banks will have to shoulder heavy loan losses occasionally. But banks are not required to raise and retain large amounts of spare risk capital, the better to survive when things go wrong. Under the international rules in place before the crash, banks could lend €30 or even €40 for every €1 put up by shareholders and available to absorb losses. Unless the loans and other investments the bank has made are super-safe, it is likely that they will struggle in a bad year. Not all banks lent €30 or €40 for every €1 they had available to cover losses, but many lent €12 or €15. If the value of their loan assets took even a modest hit, they were likely to struggle. Their vulnerability to management lending errors derives from high leverage, which means excessive reliance on debt funding in bonds and deposits.
In the Irish bank bust, shareholders were more or less completely wiped out. The scale of shareholder losses was quite staggering, totalling several tens of billions, including amounts lost in the Irish banks but also the losses of shareholders in the Irish subsidiaries of British, Dutch and Danish banks. But it was not enough: the losses greatly exceeded whatever spare capital was available. This should not have happened if the first line of defence, bank managements, had been sufficiently cautious.
The second line of defence, the regulators, also failed. Banks are subject to more intensive licensing and supervision rules than other businesses, precisely because they are seen to be such fragile institutions. If the regulators fail to spot emerging problems this second line of defence will also be breached and the State is faced with a dilemma: let the failing banks go bust or take the losses onto the national balance sheet. When a bank goes bust, the creditors as well as the shareholders lose out, and the creditors include bondholders but also everybody who has some funds deposited at the bank.
Where a small and unimportant bank gets into trouble, letting it go bust is a reasonable option, although governments sometimes opt for rescue. Where a major bank is going under, its failure could destabilise the entire system and governments almost always put the taxpayers' wallets on the line. When the US government decided to let Lehman Brothers go down in September 2008, it was an exceptional decision. In Europe, banks were routinely rescued in several countries, inside and outside the eurozone, with losses inflicted on creditors only rarely.
Since banks are very sizeable institutions, the potential exposure of taxpayers is enormous. It would be regarded as intolerable if taxpayers were exposed to the failure of non-financial institutions on the same scale. If all of the household names in Irish manufacturing and retailing were to go bust simultaneously, the rescue bill for taxpayers would rival the €64 billion spent on bailing out bank creditors. But no sane government, even if it had the money, would bail out a failing manufacturer, or a failing supermarket chain. Waterford Glass was allowed to go under, for example, along with hundreds of retail businesses in recent years. But no failing business inflicts collateral damage like a failing bank, particularly a large one. Moreover banks are interconnected in the minds of their creditors, so the failure of one can instigate a panic and the failure of all, which is not true of manufacturers or retailers.
The bank busts around Europe pushed several governments close to insolvency through the costs of rescuing bank creditors. Public debts in many countries are now so large that a repeat performance would destroy the government bond market along with the banking system. In order to prevent a recurrence, several reforms have been progressed. In particular new procedures for bank supervision, including a centralised system in the eurozone, have been put in place.
But bank supervision is difficult given the impenetrable nature of bank balance sheets. As Cormac Butler pointed out in The Irish Times last week, the banks are not required to book loan losses once they know they are likely: international accounting standards require them only to register loan losses after they have occurred.
It is remarkable that the International Accounting Standards Board continues to countenance this concealment. What outside investor (or regulator) could really have known, even if on high alert, that some of the Irish banks had made such dodgy property loans? Even in the absence of a banking inquiry, it is clear that even the boards of some of the banks were poorly informed about the low-quality lending that had been undertaken. Exclusive reliance on better board oversight, or better supervision, is likely to prove a disappointment.
The reforms that would make a real difference are proper accounting, an end to over-leveraged banking and an end to state subsidy of bank creditors. Banks, under the new rules agreed as 'Basle III', the post-crash template for bank capital, will still be allowed to operate with too little shareholder equity, which means too little spare reserves to absorb losses.
To make this situation worse, governments have failed to deal properly with the problem of bank resolution, that is, what to do when a bank becomes insolvent. The losses should be imposed, first, on the bank's shareholder capital, of which there continues to be too little; second, on bank bondholders, and finally on wholesale lenders to banks. Small retail depositors should be covered, at a cost deducted from the interest they receive, by a self-financing deposit insurance fund.
The US has moved closest to a system of this type. Unfortunately in the eurozone the banking industry has resisted reform, including reform of accounting standards, with considerable success.
If you were asked which European industry receives the largest subsidies from government, you would probably pick the railways, farming, or some dying heavy industry like steel-making or shipbuilding. You would be mistaken. According to a recent IMF study, banks in Europe receive an annual hidden subsidy estimated at up to €200bn, more than the entire annual expenditure of the EU Commission for all purposes.
The subsidy corresponds to a wholesale cost of funds to banks between 0.6 per cent and 0.9 per cent cheaper than it would be without the expectation of creditor bailout if the bank goes bust. This huge subvention, which benefits the 'too-big-to-fail' banks disproportionately, is never voted through parliaments. In most years it does not even arise. And then along comes a monster banking crash and the bill is presented in the middle of the night, and usually paid, all in one go.
The subsidy will be eliminated when governments threaten credibly that there will be no more bank bail-outs. This needs rules requiring higher levels of loss-absorbing shareholder capital in banks as well as a deposit protection scheme for the retail customer. The most common objection to this type of reform is that future bank busts would result in chaos, the meltdown of the financial system and ultimately higher social costs than are currently being endured.
But future bank busts would be less frequent and more readily contained. If banks had adequate risk capital to contain moderate losses, instead of the wafer-thin equity required at present, several European banks that required bailout would have survived under their own steam. Without the expectation of bailout, wholesale lenders to banks would have thought twice about financing the explosive growth of mono-line property banks in Ireland or the American adventures of the German state-owned regional banks. The pre-crash system, largely unreformed in the eurozone, was and remains riddled with incentives for bank managers to incur risks at the expense of taxpayers.
Some European governments are encouraging banks, whose profits are recovering, to raise more equity capital. They should also ban the payment of dividends until adequate capital levels are reached.