Wednesday, April 21, 2010

Big Banks, Regulation, and Greece

This front-page piece in the New York Times this morning is a good summary of what the major players in the financial legislation debate are saying. There are a number of voices (including some of the ones I have already mentioned) arguing (misguidedly as I've argued) for the breakup of large banks, bringing back Glass-Steagall, etc. I thought that this quote from Gary Stern was important:
Gary H. Stern, the co-author of “Too Big to Fail: The Hazards of Bank Bailouts,” said policy makers largely ignored the warnings contained in the title when the Brookings Institution published the book in 2004.

Mr. Stern, who retired last year as president of the Minneapolis Fed, is lukewarm about the bill. “It tries to address the problem but it’s half a loaf at best,” he said. “It doesn’t address the incentives that gave rise to the problems in the first place.”

In Mr. Stern’s view, ending “Too Big to Fail” should subject uninsured creditors — bondholders — to losses if the bank fails. Without that fear, he said, unsecured creditors will not exert discipline on the banks by monitoring their risk-taking and pricing their loans appropriately. Mr. Stern said the bill in the Senate is vague about how such creditors would be treated if the government were to seize and dismantle a failing bank.
That seems important to me. There is no good reason for implicit or explicit insurance of any bank liability holders other than small depositors. Taking away the implicit insurance can only help the moral hazard problem.

One commenter yesterday made an important point about Greece. I think the underlying principle is that monetary policy, fiscal policy, and financial regulation are inextricably linked. I'm wondering if the EU is not doomed to fail given how it was set up. How can one have a monetary union without somehow linking the fiscal authorities of the members with the central bank? The simplest solution in the current context would seem to be that, if the other EU members want to keep Greece in the club, the ECB should just take on more of its debt. It can sterilize by selling some other assets. My guess is that the rules the ECB operates under do not allow it to do this. Maybe someone can fill me in on what the rules are. What exactly is on the ECB balance sheet?

One last point. I'm beginning to think that the following might be an optimal arrangement. Why not have a setup where the central bank is the sole regulatory authority, with all large financial institutions having reserve accounts and access to the central bank's lending facility? The central bank would have authority to regulate financial institution risk, and the power to take over any institution and resolve it, if it deems it insolvent. Also: no deposit insurance.

6 comments:

  1. Stephen,
    I agree with you when you said:
    "The simplest solution in the current context would seem to be that, if the other EU members want to keep Greece in the club, the ECB should just take on more of its debt. It can sterilize by selling some other assets."

    This would be equivalent to an asset swap by the ECB between Greek bonds and Germand bonds for example. The problem is that Germany will NEVER let this happen. I think Germany wants the ECB to buy Government bonds more or less proportionnaly to the weight of each member country. Rumour has it that last fall, ECB started buying Greek bonds disproportinaly to keep Greek yields under control and Germany intervened to stop this practice.

    I am becoming increasingly convinced that a full fledge bail out of Greece is politically impossible in Germany. I do not see any other options for Greece other than a default (and not in the distant future...). An Argentinian scenario is, unfortunately, not outlandish.

    Politicians should not have listenned to economists that don't understand basic elements of Central Bank operations when they set up the Euro zone system. This system was doomed to fail from the start.

    Cheers,
    Qc

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  2. "The simplest solution in the current context would seem to be that, if the other EU members want to keep Greece in the club, the ECB should just take on more of its debt. It can sterilize by selling some other assets. My guess is that the rules the ECB operates under do not allow it to do this. Maybe someone can fill me in on what the rules are. What exactly is on the ECB balance sheet?"

    Something I've been trying to understand too, ever since I read this bit by Peter Boone and Simon Johnson: http://www.marginalrevolution.com/marginalrevolution/2010/04/austrogreek-business-cycle-theory.html

    If the ECB makes loans to commercial banks, and only uses Eurozone government bonds as colateral for those loans (repos), then the asset on the ECB's balance sheet ought to be those liabilities from those commercial banks.

    But I don't understand how the Stability and Growth Pact helps limit money creation by the ECB. Unless it was designed to try to prevent Eurozone governments from ever getting into a Grecian mess, where the ECB would need to bail them out by buying their bonds directly?

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  3. So it appears that there are no explicit rules about whose debt the ECB holds, but individual members (particularly powerful ones like Germany) are able influence these decisions. It seems like the ECB should be more independent, but maybe that's a political impossibility - thus, maybe the EU is ultimately doomed.

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  4. Well, in a sense Germany has a point. They have been pushing austerity measures (wrongly in my view) down their citizen throat to keep their debt under control for the last 15 years, while other countries did not shy away from having the benefit of economic growth through higher deficit spending. So if ECB would start swapping Greek Bonds against German or French Bonds unlimited, Germany and France would consider this as "rewarding bad behaviour". Therefore, this move by the ECB might save Greece and other PIIGS countries, but it would still represent the end of the EURO experience: Germany would opt out and go back to their Deutchmark.

    Either way, the Euro experiment (not the EU as a political entity) is doomed.

    Qc

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  5. I think that ECB can only hold Eurozone government bonds as colateral (not the same as owning them, of course), if those bonds are rated AAA(? or something). So if Greek bonds lose that rating (as they presumably should), God only knows what happens then (if the rules were enforced, which of course they won't be, just as the Stability and Growth pact wasn't enforced).

    As far as I see, the Eurozone is just half a dozen Argentinas waiting to happen.

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  6. Qc wrote: "Well, in a sense Germany has a point. They have been pushing austerity measures (wrongly in my view) down their citizen throat to keep their debt under control for the last 15 years, while other countries did not shy away from having the benefit of economic growth through higher deficit spending."

    There's plenty of blame to go around in the Eurozone crisis. For instance, while Germany was forcing austerity down its citizens' throats in the 2000-2006 period, the ECB held European interest rates low to support German growth. The rates were inappropriately low for the PIIGS, which then saw high inflation, capital inflows and an increasingly indebted populace. Now, post-crisis, the capital has fled leaving high unemployment (Spain's unemployment is at 20% as it's building boom, funded by cheap capital has collapsed), uncompetitive wages (from the inflation), and high levels of public and private debt. Greece may have handled its fiscal policies exceptionally poorly, but all of the PIIGS are in trouble in part because of the interest rates held low for Germany's sake.

    Another issue that is rarely raised is the ECB's differential treatment of systemic risk in Northern and Southern Europe. When the financial crisis hit, the ECB created unprecedented liquidity facilities to prevent the European banking system from collapsing. These facilities were primarily accessed by French, German and Benelux banks. The banking system in Southern Europe, on the other hand, was much more sound, in part because of tighter regulation and did not require as much support from the ECB (just consider the fact that Spain's big banks did not fail, in spite of the huge housing bubble in that country).

    Now, two years later, as Northern Europe's financial system has stabilized, Germany is complaining about ECB's treatment of Southern Europe's fiscal instability. In 2008, saving German banks was appropriate, but now in 2010, saving Greece is verbotten.

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