Ireland’s effective underwriting of its entire banking system for two years has set a super-high bar for European Union-wide crisis coordination but it may now be the base line needed to restart frozen interbank money markets.
Dublin’s unilateral step has been widely criticized for dramatically skewing the “level playing field” for intra-EU banking competition by lumping its taxpayer with potentially vast liabilities and protecting banks’ shareholders. But it has concentrated minds across the continent. Germany, Greece and Denmark have since indicated they will also guarantee depositors’ cash, and the UK Treasury said it’s prepared to take “radical” action if needed.
Yet the crucial difference that sets Ireland’s plan apart is that its government not only guaranteed savers’ deposits but also banks’ wholesale liabilities. That is to say, an institution lending to an Irish bank on interbank money markets now knows the borrower is good for the money because it has a government guarantee behind it. And that difference is critical because the potential cost of effectively underwriting bank-to-bank lending compared with “just” retail deposits is incalculably higher.
Ireland has guaranteed some €400 billion ($550 billion) in total, just over double its entire annual economic output. Roughly half of the funds guaranteed are retail deposits. If these figures are extrapolated across the EU, where total economic output last year was almost $17 trillion, it’s easy to see the scale of the crisis.
The latest European Central Bank money supply figures showed all currency in circulation, overnight deposits, deposits of up to two years and other short-term deposits totaled almost €12 trillion. The EU’s political, tax and legal structures prevent a sweeping financial rescue package for the continent like the $700 billion bill likely to be passed in the United States.
But as the financial crisis deepens and broadens, the question facing Europe is less one of whether coordinated action at a regional level is needed, but how far coordination goes for limits on guarantees for bank depositors, recapitalization of battered banks and even wholesale banking exposure. “What we need is targeted global money market action .... otherwise we could be facing financial and economic collapse,” said Neil MacKinnon, chief economist at ECU Group, a London-based hedge fund. “That may require governments effectively underwriting the interbank market in some shape or form, for a while, just to get banks lending again,” he said.
Credit markets have been in a deep freeze and financial markets of all hues in a state of flux in recent weeks since the collapse of US investment bank Lehman Brothers pushed the 13-month long credit crisis into its darkest phase yet. Since Lehman’s demise, market conditions have deteriorated rapidly and banks have been nationalized, forced into shotgun marriages or rescued with the aid of taxpayers’ money.
Last week five European financial firms were brought under state control or rescued, joining US-backed bailouts of Fannie Mae, Freddie Mac and American International Group. Even if the nuclear option of underwriting the entire banking system is avoided, Europe needs to act as one. “The only way to get policy responses to help in the aggregate is to coordinate at least at the Europe level,” said Willem Buiter, professor of economics at the London School of Economics and former Bank of England official. “We won’t get a European (bailout) fund because there’s no central European tax authority, but we could have national funds according to a European template, playing by European rules,” he said.
The precedent some analysts point to is Sweden, which effectively nationalized its banking system in the 1990s to save it from total collapse. The government guaranteed deposits and took equity stakes in institutions. That cost Sweden up to 4% of annual gross domestic product but is thought to have paid for itself over time. A paper published last month by two International Monetary Fund economists showed that the average cost of national banking sector bailouts over the past 30 years to be 16% of GDP.
Banks currently refuse to lend to each other because they’re scared of what state the counterparty’s balance sheet is in. Central banks have thrown trillions of dollars of liquidity at banks to cajole them into lending again, but in vain. What banks need is the incentive to lend again, conditions which would be reflected by a steeper yield curve. That is, the ability for banks to borrow cheaply over short time horizons and lend that money out over longer periods at higher rates of interest. Three conditions need to be met before the wheels of the global financial system start to slowly turn again: liquidity, solvency and confidence.
Monetary authorities have addressed the first issue through their myriad provisions, injections and facilities. But the other two remain cause for serious concern. Michael Gallagher, head of G7 strategy at IDEAglobal in London, pointed out that the ECB is already effectively acting as the sole clearing agent for Europe’s banking system, taking in record deposits from banks too scared to lend one another then shunting funds out to financial institutions in huge quantities.
“If this rumbles on, you get tension about deposits, so it is possible that echoes of this (Ireland’s guarantee) could be copied elsewhere ... or a euroland-wide move could be put together, though with a higher minimum limit rather than an Irish style unlimited cap,” Gallagher said. “I’m not surprised at this, given recent events, but it’s not healthy if it continues,” he said. (Reuters)