Willem H. Buiter CBE, FBA Professor of European Political Economy London School of Economics and Political Science

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1 Willem H. Buiter CBE, FBA Professor of European Political Economy London School of Economics and Political Science

2 1. The financial crisis of the north-atlantic region that started in 2007 is, by most metrics, the biggest financial crisis ever 2. The global contraction of real economic activity that followed it will undoubtedly be the deepest and longest downturn since the Great Depression 3. If policy makers screw up, it could still become worse than the Great Depression 4. I don t consider that likely 2

3 Today s advance industrial country financial crisis are rather like the EM crises of the 1970s, 1980s and 1990s. Dysfunctional banking and financial systems Frozen impaired financial markets Lack of fiscal spare capacity Convergence of public sector & banking sector credit ratings (in a crisis, all debt is public) risk of sudden stop Double crisis : banks and sovereign debt Triple crisis: banks, sovereign debt & currency Main difference from EMs: global reserve currency status of US & Eurozone 3

4 Pay special attention to the inconsistent quartet Small country Large internationally exposed banking sector Own non-global reserve currency Limited fiscal spare capacity Iceland, Switzerland, Sweden, UK, Ireland (3 out of 4) 4

5 After the banking crisis and the (private sector) financial crisis are we entering a period of sovereign debt crises and currency crises? If so, will it be restricted to EMs and small countries (especially in CEE), or will it involve larger countries, including the UK & the US? 5

6 Financial excesses (credit booms, asset bubbles) as bad in Eurozone as in US and UK Positive exceptions: Spain s dynamic provisioning Italy s stay-at-home conservatism (except for UniCredit & Intesa Sanpaolo ) Negative exceptions: Spain s wild construction boom/bubble Ireland s wild construction boom/bubble Ireland s banking bubble Germany s Landesbanken Lending to CEE & Balkans Lack of transparency of Euro Area banks; failure to recognise losses & start recapitalisation Euro Area behind US, UK and Switzerland in recognising bank losses and addressing recapitalisation 6

7 Real economy downturn at least as deep in Euro Area as in US & UK. 7

8 Positive: Euro Area: Common Currency, LLR, MMLR European Commission (Competition Directorate) attempts to preserve competition in banking despite egregious state aid & new banking Darwinism (survival of the fattest and the politically best-connected) Less protectionism among EU members towards each other 8

9 Negative No common policy on deposit insurance No common policy on unsecured creditors of banks No common special resolution regime (SRR) with structured early intervention (SEI) & prompt corrective action (PCA) No common policy towards recapitalising banks No common policy towards guaranteeing assets or liabilities, new lending or new borrowing No common fiscal stabilisation measures, modulated according to fiscal spare capacity Strong protectionism in financial and posted workers areas. 9

10 ... even if it is sound something most crossborder north-atlantic banks are not, but for past, present and anticipated future government financial support Banks need: the Holy Trinity of financial stability 1. Liquidity support (central bank as lender of last resort & market maker of last resort) 2. Solvency support (Treasury as recapitaliser of last resort) Because of 1. and Banks get regulation & supervision 10

11 Reasons banks become too big, too interconnected, too complex and too international to fail: 1. Economies of scale 2. Economies of scope 3. Monopoly power (scale in a given activity) 4. Conflict-of-interest synergies (bundling many activities) 5. Lobbying power/political clout 6. Tax arbitrage 7. Regulatory arbitrage 8. Desireto become too big, too interconnected, too complex & too international to fail 11

12 Too big to fail means too big to be private Public ownership of very large institutions Smaller private banks and other financial institutions capital ratio requirements increasing in size of bank More aggressive anti-trust & competition policy (European Commission) Separate investment banking from commercial banking Prevent conflicts of interests within investment banks and commercial banks by unbundling further (Glass-Steagall on steroids) No public (listed) companies in investment banking No economic efficiency problems: economies of scale in banking exhausted before $100 bn balance sheet. Economies of scope non-existent (span of control and lack of focus problems). In the short term, fewer and larger banks In the medium term, more and smaller banks 12

13 Classic example of market discipline undermined by political economy considerations Too big to fail is a financial stability myth, but a powerful political economy reality Orderly resolutions of bankruptcy/defaults/insolvencies of even the largest banks and financial institutions are easy 13

14 Requires Special Resolution Regime with Structured Early Intervention and Prompt Corrective Action pre-empting Chapter 11 & Chapter 7: regulatory insolvency joins balance-sheet insolvency and liquidity insolvency. Ability to ring-fence payment, settlement, clearing, custodial activities of banks (& possibly counterparties of banks also). (Possibly) counterparties (CDS holders) senior to unsecured creditors Clarity on the exact seniority ordering of all claimants Political strength to resist pressure from unsecured creditors (pension funds, insurance companies, other banks) and other lobbyists 14

15 Assets Good Bank -Bad Bank Deconstruction of RBS Group end-2008 Balance Sheet (following the Bulow-Klemperer-Hall-Woodward approach) ( bn) RBS Good Bank Bad Bank Clean assets (good& bad) 1,012 1,012 - Toxic assets Derivatives Equity in other bank Total assets 2,330 2, Liabilities Deposits Debt securities & other non-deposit liabilities Derivatives Total liabilities 2, Equity Total liabilities & equity 2, Capital ratio 0.34% 20% 1.7% 15

16 Central banks, Treasuries and regulators/supervisors are national Repatriation of cross-border banking No more cross-border branches regulated & supervised by home country (Icesave) EU principle of mutual recognition, single passport RIP Only independently capitalised subsidiaries, with own assets & liquidity; managed at arm s length from parent & regulated & supervised by host country Home country Treasury cannot be expected to bail out foreign subsidiaries of national banks 16

17 Special problems of the EMU 1. One central bank for 16 countries 2. No fiscal Europe 3. No European regulator-supervisor for bordercrossing systemically important financial institutions. 4. Because of 2., credit easing by ECB/Eurosystem problematic: who recapitalises the ECB? 17

18 Central bank s conventional equity, W,need not be positive, but its comprehensive net worth, V = W + S E T, must be positive, lest it either is at risk of failing to meet its financial obligations, or will have to raise S and thus future inflation to restore solvency. Restoring solvency even through seigniorage may be impossible if the exposure of the central bank is to foreign currency assets or index-linked assets. In that case only a low or negative realisation of T can restore central bank solvency 18

19 ECB itself small and irrelevant Eurosystem (ECB + 16 Euro Area NCBs) large and relevant, but not fully integrated NCBs share losses incurred as a result of Eurosystem monetary operations, liquidity operations and credit-enhancing operations NCBs do not share losses incurred by NCB acting as quasi-fiscal agent for national Treasury NCBs do no pool capital. 19

20 Eurosystem Assets, 08/-5/2009 Assets (EUR millions) 1 Gold and gold receivables 240,817 2 Claims on non-euro area residents denominated in foreign currency 159,299 3 Claims on euro area residents denominated in foreign currency 123,101 4 Claims on non-euro area residents denominated in euro 21,359 5 Lending to euro area credit institutions related to monetary policy operations denominated in euro 653,352 6 Other claims on euro area credit institutions denominated in euro 26,453 7 Securities of euro area residents denominated in euro 292,405 8 General government debt denominated in euro 36,790 9 Other assets 241,523 Total assets 1,795,099 20

21 Eurosystem Liabilities, Liabilities (EUR millions) 1 Banknotes in circulation 759,502 2 Liabilities to euro area credit institutions related to monetarypolicy operations denominated in euro 264,137 3 Other liabilities to euro area credit institutions denominated in euro Debt certificates issued 0 5 Liabilities to other euro area residents denominated in euro 139, of which General government 130,717 6 Liabilities to non-euro area residents denominated in euro 177,993 7 Liabilities to euro area residents denominated in foreign currency 1,548 8 Liabilities to non-euro area residents denominated in foreign currency 11,407 9 Counterpart of special drawing rights allocated by the IMF 5, Other liabilities 159, Revaluation accounts 202, Capital and reserves 72,840 Total liabilities 1,795,099 21

22 Consolidated financial statement of the Eurosystem asat 8 May 2009: Bad news: Eurosystem has only 74 bn of capital and reserves & 1,795 bn worth of assets, i.e times leverage Good news: Eurosystem s balance sheet is 20% of Euro Area annual GDP & monetary base ( 1 trillion, 75% currency) is about 11% of GDP ( 9.2 trillion) 22

23 With 4 % trend nominal GDP growth a reasonable seigniorage benchmark is 0.33% of GDP each year (currently 32bn)( required reserves are remunerated). If long-term safe interest rate exceeds long-term growth rate of GDP by one percent, capitalised value of seigniorage is 33% of GDP, more than 1.5 times the balance sheet of the Eurosystem. Safe but beware: growth of balance sheet of Eurosystem Financial development and crime-fighting could reduce seigniorage revenue 23

24 Is the ECB too independent to play a Euro-Area-or EU-wide role as regards macro-prudential supervision & regulation? ECB may have to chose: independence and irrelevance or less independence and greater relevance. 24