05.06.2009
It's still coming
By: Adam S. Posen
It seems unfair. This was supposed to be a US crisis. And now it turns out that the real banking mess is still coming for the eurozone, where countries were much more careful with their bank supervision than the US. Yet, this assessment is misguided on two counts: first, many euro area banks got into serious trouble of their own, despite supposedly better regulation than in the Anglo societies; second, economic life is not always fair.
This mess is sizable. The latest IMF Global Financial Stability Report estimates that a minimum of $375 billion of capital will need to be injected into euro area banks, and perhaps as much as $725 billion (compared to $275 billion to $500 billion for the US banking system). Goldman Sachs analysts writing a couple of months earlier came up with a similar scale estimate of $571 billion capital shortfall. No one can say for sure. If we knew how much each bank had lost and which banks had lost it, the crisis would be half over. But throughout Japan’s lost decade of the 1990s, averaging the Goldman and the IMF estimates of bad loans turned out to be pretty reliable. If one counts up the amount of issuance of questionable securities, and the expected losses on real estate to come, and subtracts the known losses in the US, UK, and Switzerland, one ends up with about that number, and those remaining losses have to be in the euro area.
The sizable mess will also have a sizable impact. Traditional bank activities remain hugely important to the euro area economies. Most corporate financing comes in the form of collateralized bank loans. A significant share of household savings is kept in savings accounts of various forms. While the exact proportions vary from country to country, further disruption of banking will starve a wide range of businesses of capital, and a large number of households of returns on their savings. In other words, a given capital loss at banks in the euro area will have a larger impact on real economic outcomes than the same size shock to capital would have in the US or UK, where traditional banks played a smaller role. So much for the stabilizing effects of boring banking.
Trying to prevent this negative impact will be difficult. The European Commission announced last week its plan for immediate measures to deal with European banking fragility. But it is not sufficient. The experience of the last 30 years shows that it is difficult to summon the political will to truly confront banking problems. The government has to go further into debt, spending taxpayer money to recapitalize the banks, while closing some banks and thus cutting lending, if it is to fundamentally resolve the situation. Nothing in the Commission’s plan forces the national governments to put up the needed money or to close the right banks.
Sweden in the early 1990s is rightly held up as the example of how to this; Japan from 1995 to 2001 is rightly held up as the example of how not to do this. The difference comes down to how the government is forcing the banks to recognize the full extent of losses, and thus of capital needs. Banks which are insolvent need to be either shut down, temporarily nationalized and reorganized before resale, merged with healthier banks, or be subject to capital injections from the government in return for some form of shares.
In Sweden, this triage worked. In Japan, public money was injected repeatedly into the banks in insufficient amounts with insufficient conditions, and the banks just wasted the money. It took three tries before they got it right in 2002. The US is now somewhere in between – public resistance to putting more money into the banks and the early signs of recovery have let the US Treasury kick the problem down the road. In all likelihood, the banks will be back for another capital injection within a couple of years, but it will not drag out a decade as in Japan.
So what remains for the euro area is a pretty gloomy economic prospect. Not only is the euro area banking mess sizable and of great import, but nationalism by member governments is making them reluctant to shut down their own banks, or to rack up extra debt for recapitalization. As in the US, the blanket guarantees on deposits and various interbank assets prevented a panic, but also likely removed much of the market pressure on the banks to behave better. A stronger European-level initiative could only help, but perhaps not until some more banks fail – we have to hope the failures are not concentrated in any one country, for that will lead to more misguided sense of fair punishment. We are all in this, together or separately.
Adam Posen is Deputy Director of the Peterson Institute for International Economics in Washington, DC.
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