Dangerous Experiments of Europe
Prof Dr Freddy Van den Spiegel, Vlerick Business School
Once again, Europe has avoided a major crisis in March 2013, this time by rescuing Cyprus and its banking system. Again, it has been surprising how a problem in a tiny economy with a small banking sector (be it large in proportion to the local economy) can lead to such important problems at the European and even worldwide level. Not much has changed since the start of the crisis in 2007. The Cyprus crisis has been remarkable for a different reason: the scenario of the events has been quite surprising. For the first time in a long series of rescue operations, Europe has put the “normal” bank deposit holder in the front line to suffer losses in a so-called bail-in operation. In the initial proposal, all deposit holders would bear losses, but that proposal was rejected by the Cypriote parliament and watered down so that deposits up to 100.000€ were still protected. But still, the consequences of this “new” approach could well be far-reaching.
Of course, it is all a matter of finding the capital, needed to manage the crisis. The shareholders of banks should be in the first row in case of trouble, but in a crisis, shareholder capital is by definition quickly exhausted. After the shareholder, the junior debt holders, like investors in subordinated bonds of convertible bonds should participate in the losses. And indeed, they have suffered in several cases in for example in Ireland and Spain. However, crisis managers have always been careful not to shock the investor community too much, and this for a simple reason: you should not be too rough with investors on which you continue to depend in the future. That same prudent approach has always been taken towards deposit holders, as deposit gathering is the only product that makes banks unique. Without deposits, there is no banking system. Therefore, other ways to finance the crisis have been preferred, going from the rescue of banks with taxpayers’ money, to the organized failure of a country like Greece, or to the almost unlimited issue of money by the central banks. There were always good reasons to avoid tackling the deposit holders: their blind confidence in the banking system has to be maintained, and as they are unable to distinguish between prudent banks and those who are taking excessive risks, they have to be rescued at any price. That is also why there are specific banking supervisors, who have access to the heart of banking decisions and should be capable to stop banks taking excessive risks. As soon as deposit holders lose confidence, the monetary system and the currency are at risk: bank runs, keeping savings at home, looking desperately for alternatives for money are all fatal for the normal functioning of an economy and its political system.
So why is it different this time? Some will claim that it is because Europe has come to the conclusion that it is unacceptable that the taxpayers continue to contribute unlimitedly to finance the crisis. That in itself is a valid point, but the question remains if all the consequences of putting the risk on the deposit holders’ shoulders are taken into account.
First, this procedure can become extremely pro-cyclical. As soon as a country and/or its banks show signs of weakness, a rational deposit holder should immediately move his savings out of that country, into banks of “safer” countries. Capital flight has already happened during this crisis for some weaker countries, because of sovereign risks. But the fear for bail-in of deposits could be far more difficult to control or manage. A run on banks would of course lead to the collapse of the banking system in the weaker country and to excess liquidity in stronger countries. According to economic textbooks, that movement would be counterbalanced by several mechanisms such as a higher exchange rate of the currency of the receiving country, which would make the weaker country more competitive. This mechanism is of course excluded in a monetary union. Within a monetary union, the excessive liquidity of the receiving countries should flow back to the weaker country via the banks for example the interbank market, but, in reality this will not happen, as the banks of the stronger country will be reluctant to invest in the weaker country. Also that phenomenon has already been observed in the Euro zone during the crisis and the only political instrument available to compensate these flows has been the central bank providing liquidity to the banks of the weaker countries. But there are limits to these mechanisms as it increasingly weakens the balance sheet of the central bank. A far more intrusive way to avoid this problem is to impose capital controls, as Cyprus is now implementing, with the agreement of the European Commission. Such capital controls are however a fundamental anomaly in an integrated capital market, and the opposite of what the Treaty of Rome (1958), creating the European Economic Community, aimed to achieve. Creating country specific unrest with deposit holders in a monetary union would well be fatal for the future of the currency.
Second, a prudent investor, could wonder if the guarantee of up to 100.000€ is really solid or if in case of serious problems, also these deposits will be used for bail-in, in line with the initial proposal in Cyprus. Anyhow keeping deposits beyond 100.000€ in banks seems increasingly a dangerous strategy. All savings above that amount should be invested outside the banking system, where the investor can try to hide for the bail in. That would bring the financial model of Europe closer to the US model, characterised by more financial market activity, more shadow banking, and a much smaller banking industry. However, Europe does not seem to be convinced that this is really the way it wants to go. Initiatives like the financial transaction tax and deep suspicion of the shadow banking system seem to indicate the contrary. Ultimately, the investor could well prefer to allocate his/her savings outside the currency area, looking for a safe haven.
Some European politicians have claimed that the bail-in of deposit holders is uniquely linked to the specificities of the Cyprus case and will not be used for other countries. However, this is not very credible, as some EU officials have clearly a more ambitious view and as the issue of bailing in savings deposits is also intensively debated in the framework of the Crisis management directive which has to be approved later this year. In other words, using the bail-in tool for deposits seems to become a standard tool in case of a banking crisis.
Without any doubt, the rescue of Cyprus seems to be managed in panic, which is surprising as the problem of its banks was perfectly known since at least two years. And the chosen political solution seems to be built on incomplete analysis and a lack of vision about the broad consequences which it could have in the longer run.
Until now, Europe has plod from one crisis into another over the last six years. Simultaneously, it has painted a broad but ambitious picture of how the European Union should look like in a distant future from a political point of view: a banking union, a political union, a fiscal union and a genuine economic union. These plans for the future are fine but they are limited to political concepts. Furthermore, they do not help us in the short run, and, as Keynes put it: in the long run we are all dead. Until now, Europe has refused or been incapable to answer a very important practical question, which should be at the basis of any regulation: which kind of a sustainable financial system do we really want?
What Europe urgently needed at the beginning of the crisis, and still needs today, is a major, credible and comprehensive master plan (or Marshall Plan) which provides clear, coherent answers and a practical roadmap to three fundamental questions.
- How can we get out of the downward spiral of excessive debt in the public and the private sector in some Member states?
- How can we bring the banking sector back to its key role of facilitating economic growth?
- How can we get the Member states on a sustainable economic growth path, in line with the ambitions of monetary, financial and economic integration?
The answers to these questions will not be easy to find and it will be even more difficult to decide how we can get where we would like to be. But without such a vision, Europe will stick to launching ambitious plans for the future, while running increasingly out of options for day-to-day management of the reality. And one day, Europe could well find itself with an empty toolbox when a new crisis hits the Union.