It's Still Coming

Column for the Eurointelligence Syndicate

June 5, 2009

It seems unfair for the euro area to be facing further banking problems. This was supposed to be a US-created crisis-and even some countries that had real estate booms, like Spain, were much more careful with their bank supervision. And green shoots of economic recovery are popping up everywhere, it seems. 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. The real banking mess is still coming for the eurozone.

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, there 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 United States, the United Kingdom, and Switzerland, one ends up with about that number, and those remaining losses have to be in the euro area.

The real banking mess is still coming for the eurozone.

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 United States or the United Kingdom, 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. True, the European Commission announced last week its plan for immediate measures to deal with European banking fragility, and it even includes stress tests. But the money is gone. And in country after country, whether in the United States over the last two years, Japan in its crisis of the 1990s, the United States (on a smaller scale) in its 1980s savings and loan crisis, and so on, that means 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 EC 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 do this; Japan from 1995 to 2001 is rightly held up as the example of how not to. The difference comes down to how tough the government is in forcing the banks to quickly recognize the full extent of losses, and thus of capital needs. Banks that are insolvent need to be either shut down (if small and of no systemic concern), or temporarily nationalized and reorganized before resale (if too big to shut down). Banks in less severe straits but still undercapitalized can be merged with healthier banks or get a topping up of capital from the government in return for some form of shares.

In Sweden, this triage of banks into viable, salvageable institutions and needing to be closed or nationalized was rather rapid and quite consistent. In Japan, public money was injected repeatedly into the banks in insufficient amounts with insufficient conditions, and the banks just wasted the money as a result. It took three tries before they got it right in 2002. The United States at the moment is likely somewhere in between-public resistance to putting more money into the banks and the hoped-for shoots of recovery have combined to 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 for 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, when other euro area countries are not yet doing either. As in the United States, the blanket guarantees on deposits and various interbank assets prevent a panic, but also likely remove 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 a more misguided sense of fair punishment. We are all in this, either together or separately.