Body
In Jackson Hole last week, Christine Lagarde, the new managing director of the International Monetary Fund (IMF), decided to step on the toes of her former colleagues at the top of Europe's financial policymaking community. This is good news. It illustrates that Lagarde, a former finance minister of France, is evidently not treating Europeans with velvet gloves. And she is absolutely right that Europe's banks (and the European economy more broadly) would benefit tremendously from an immediate government-led capital infusion. In short, she has chosen a good subject over which to show her independence and pick a fight with her former colleagues, many of whom supported her for the IMF job.
It is strictly true, as argued by European Central Bank (ECB) president Jean Claude Trichet before the European Parliament this week, that as long as the ECB provides unlimited liquidity to euro area banks, they are unlikely to face any liquidity problems, as they have enough "ECB eligible" collateral. This is even more so, as the ECB has authorized national central banks—as in the case of Ireland—to lend even more liquidity to domestic banks when they ran out of such "ECB eligible" collateral. It is also strictly true, as argued by EU Commissioner Olli Rehn this week, that European banks have raised more than €50 billion in new capital this year and are in better shape than before.
But both Trichet and Rehn miss the crucial point that too many European banks remain undercapitalized, despite having passed the most recent EU bank stress tests this summer. The main reason that funding conditions for European banks have tightened in recent weeks (and their stock market values have plummeted)1 is the return of counter-party concerns among participants, such as US based money market funds, in Europe's wholesale funding markets. Markets fundamentally don't believe that many of Europe's banks hold enough capital. They thus question the solidity of the entire European banking system.
Because credit markets tend to focus on worst-case scenarios, the risk of financial market contagion from new jolts to the EU economy is high. Responsible policymakers ought to take urgent measures to reduce it. Or put in another way, given the fragility of confidence in Europe's financial system, it would be prudent of EU officials to move forcefully to put more capital into numerous EU banks, rather than wait for years to enable the banks to rebuild capital slowly from retained earnings and occasional new equity issuance.
The need for more capital in Europe's banks now looks particularly urgent because of the risk that the Greek restructuring plan might unravel in the coming weeks. In this regard, the Greek government's demand that 90 percent of bondholders agree before September 9 to participate in the planned debt rollover looks like a deadline that was set up to be missed. Such a failure would pave the way for the deeper restructuring of Greek debt that most analysts have known would happen eventually. As a result, there could be higher haircuts imposed on private banks sooner than many anticipated, perhaps this year.
An interesting twist to this issue is that the biggest "private owner" of Greek government debt among EU banks is the German government. Its two "bad banks" FMS Wertmanagement (bad bank for Hypo Real Estate) and Erste abwicklungsanstalt (bad bank for WestLB) own a total of €8.8 billion of Greek bonds, taken over by the German government from crisis-stricken German private banks . Without the participation of these two "German bad banks," it will be very hard to reach the 90 percent participation target for voluntary rollovers.
The German government's failure to help Greece get 90 percent participation from the debt rollover is striking. It indicates, perhaps, the interest in Berlin in proceeding to a more thorough Greek restructuring more rapidly. That, after all, was Berlin's preferred option going into the euro area summit on July 21. The signaling effect of a continued lack of commitment from Europe's strongest economy would almost certainly doom the planned bond swap.
Moreover, when European leaders met on July 21, they for the first time gave themselves the tool kit to inject capital into ailing European banks across the euro area (subject to pending parliamentary approval). The European Financial Stability Facility (EFSF) will now have this capacity to act in the same way as the US government TARP-sponsored Capital Purchase Program (CPP). Launched in October 2008, that program was designed to bolster the capital position of viable financial institutions of all sizes and thereby build confidence in these institutions and the financial system as a whole2. Lagarde, who followed the US situation closely with well-publicized telephone calls to Treasury Secretary Henry M. Paulson, now seems to be calling for Europe's leaders to actually use the tools created to fight the crisis as soon as they have been approved by national EU parliaments.
Alas, there is little reason to believe that EU leaders will follow Lagarde's advice and inject government money into Europe's undercapitalized banks, however. The politics of launching another taxpayer bailout of banks in Europe are too big an obstacle unless or until the crisis reaches a new acute phase. Taxpayers will surely revolt at the idea of a second round of "bank bailouts," as will entrenched and politically protected euro area banks and their regulators and existing shareholders. The time may come before long when they realize that they should have listened to her recommendation.
Notes
1. These pressures can be gleaned from both the rising levels of capital parked by banks at low yields overnight with the ECB and the rising usage of ECB liquidity by European banks. See ECB weekly financial statements.
2. See Troubled Asset Relief Program: Two Year Retrospective , October 2010, US Department of the Treasury, Office of Financial Stability.
