Bank Bailouts: The Correct Way

Some time ago, a book I read stated that the very nature of capitalism was to allow firms to die without any consequences to the system. The author wondered why the same thing isn't possible with banking institutions. That author was Nassim Nicolas Taleb and the book was titled Black Swan. (However, I wouldn't really recommend the book) Although at first I thought the author was right, after considering it I realized that the banks are not at all like any other firm.

If tomorrow Google were to file for bankruptcy, the consequences would be a lack of a good search engine and thousands of Google employees left without a job (and you wouldn't be reading this!). Otherwise, no harm would be done to the ordinary person. Now imagine what would happen if one of the major banks were to collapse: millions of people would suddenly be worried of being left with little or no money (although a country guarantees approximately 100,000 euros of deposits by each person in each bank). In the end, people would get their savings back (expect the persons which had amassed millions who will only get 100,000), however, the whole procedure would be traumatic to the ones who were unlucky enough to get caught in it. Nevertheless, such a procedure is preferred to the cost of pumping a bank with new money every now and then just to sustain it.

Thus, the question becomes: When should banking institutions be rescued? The answer is simple, although it may be tricky to define at times: When they are solvent, largely problem-free and have faced trouble only as a result of an unpredictable event to which they bore minimal or no responsibility. This, for example, would be the case with most EU banks which suffered great losses from the Greek haircut (although there were other banks which had overextended credit over the years).

If a banking institution is thought to be worthy of rescue then the course of action should be by directly providing liquidity to them. This would mean that governments, Central Banks or (preferably) an institution like the ESM, should provide liquidity to the banks; with the latter issuing new shares with voting rights, committing to repurchase them at an amount obtained after accounting for a fixed interest rate, and agreeing that the institution's participation in the bank's equity capital would be reduced each year, thus making sure that the stream of payments from the bank to the state would be continuous. Even if government (or Central Bank) intervention in banking institutions is not considered a good thing, it is much better than merely purchasing preferred shares, as the very recent Barclay's example indicates. By agreeing to pay interest on the amount given to them and repurchasing those shares at fixed intervals, it is assured that the taxpayers' money is not just thrown down a bottomless pit, making the banks more careful in their future investments and gradually reducing government intervention within them.

Following this, the distressed bank should implement some austerity measures, either by cutting down salaries or other benefits or, better, by reducing its activities both at domestic as well as at an international level. Needless to say, the bank's heads at the time of government intervention should be replaced. The bank could spin-off some of its operations if they are profitable, however, this should be done in a way that the new company is an independent one and not with the bank still controlling a substantial interest in it. Likewise, the spin-off should not be sold to another bank as this would increase the other bank's risk of becoming too-big-to-fail.

In the case of the bank becoming insolvent, problem-ridden with issues which are not due to unexpected events (e.g. management issues, poor lending decisions, etc) then it should be let collapse just like any other ordinary firm. If the bank has some operations which are profitable and well-functioning, then these should be spun-off, or sold to another company, even though selling them to another bank should be avoided for reasons of the other bank becoming extremely large. What the reader may inquire is what if the second bank is already too big? What difference would it make if the profitable operation is sold to them? First of all, a new spin-off will require more employees (think of new management, trainees, secretaries, even cleaners) than if it is sold to another company where existing economies of scale would take over. This would have a positive effect on unemployment especially since other bank's employees are expected to be laid off as a result of the collapse. Then, even the acquiring bank is already too big, in what scenario would the government (or another institution) be spending less for stabilization: saving a 100 billion bank or a 105 billion bank? And remember that's billion...

Under the current scheme, most banks are either classified as too big to fail or too little to have any exposure. Take the UK for example where only 5 independent large banks exist, with the government having interest in two of them. What should have been done was to reduce the level of activities of the Royal Bank of Scotland and Lloyds Banking Group to levels where such intervention would be easier in the future, also allowing the creation of more banking institutions, which would promote a competitive environment instead of an oligopolistic one.

5 Causes of Financial Instability in Europe

As the EU crisis continues to unfold, many academics, investors as well as everyday people have lost their faith in the Union. They view more weaknesses than strengths in the Eurozone structure, and are under the idea that these weaknesses will lead the Union to its doom. On the other hand, there are those who have the firm belief that the EU will make it through, even if it takes some troubled years, and will emerge stronger and more unified from the crisis. 

Both groups are correct up to a point: Although the destruction of the EU does not seem eminent, there are some important issues which undermine the well-being of the Union. The most important of them are:

(i) A non EU-wide bank regulating authority. Currently, the EU member-nations have the sole responsibility to regulate, supervise and recapitalize their banks. A separate authority should be created in order to monitor banks and have the sole responsibility for their  recapitalization. This authority will comprise of officials from all EU member-states. Thus, if a bank recapitalization is needed the host country will not have to directly move to guarantee it as the authority will be responsible for it. In this way, the countries do not have to use their tax-payers money in order to bail-out the institutions.

(ii) Excessive public spending by EU governments (especially in the South). Unfortunately, people in the South knew that their governments were overspending years before this crisis occurred. Not to be fooled though, Northern nations were overspending as well (e.g. Germany, Austria and many others). However, everyone kept silent about this as no trouble had yet happened. The Stability and Growth Pact, as well as the Sixpack and the Euro Plus Pack which followed, are great ideas, nevertheless with little implementation. The reason is simple: what will stop a nation from having a large deficit if it needs to? Nothing at all. While the Packs and Pacts are full of proposals and ideas there are no "punishments" for those who wish to deviate from them. What happened when Germany had public debt of more than 70% of GDP for three consecutive years? Nothing. What will they do after the crisis ends? Return to the Packs and Pacts and after 3-4 years when all is forgotten governments will once again start spending more. The issue is not for the small nations. If Cyprus, Greece or even Italy are sanctioned by the EU they will most probably do as they are told. Will Germany do the same? I highly doubt it. 

(iii) Lack of ECB independence and discretion. As of the current regulatory framework, the ECB cannot act on its own will as it has to have Member-States' permission.  This makes the procedure of aiding an ailing nation or banking institution much slower and bureaucratic. Under the current scheme the role of the ECB is not the one of real Central Bank, like its counterpart in the US. If the ECB is not allowed to function autonomously then there is almost no need for its existence. The need for a better Union is tied together with a need for an autonomous bank which is allowed to act at its own discretion.

(iv) Non-integration of institutions, in favor of common policies. Most of the institutions in the EU have restricted powers and this does not allow for much to be done. Also, under the current structure, the only authority "paid to think European" is the European Commission. Thus, the need for more institutions which are EU-orientated in their policies arises. Aside of this, the aspect of granting more powers to the EU institutions is an issue which has to be settled. If the institutions are allowed to function as they should then more political union would occur in the region, thus making it easier for the monetary union to survive.

(v) Member-States leaders who believe the EU is their protectorate and have the notion that in order for anything to be done they have to grant their permission (Wonder who this makes me think about Angela....)

Do we need a Crisis?

When people face difficulties, it is always easier to blame someone else for their mishaps. When a nation views its own problems, and as nations are governed by people, it is more than easy to criticize and assign fault to others. The same has happened now, as many Northern Europeans believe that the responsibility for the crisis lies only on the shoulders of Southern Europeans who, "do not work enough".

This, however, couldn't be farther from truth. Although South Europe is portrayed in the media as a place where everyone is constantly partying and nobody is working this seldomly depicts real life in the South. Germany on the other hand has the reputation of being a hard-working country. Still, German working hours are amongst the lowest in the world. So is France's. Look at the following chart comparing work hours in the OECD countries:

So what happens here? Are the poor Greeks and Italians working hard the whole time but the bad Germans take the GDP from their hands? In all fairness, no. It seems that although South Europeans are working many hours, what they lack is productivity. A quick glance in Wikipedia may help: Italy, Greece and Cyprus have below average productivity. Specifically, in the case of Cyprus and Portugal, their productivity is much lower than the EU average.

The only difference, is mentality. While Germans and French work less, their time put to better use and thus their productivity is greater. On the other hand, whilst Greeks, Italians, Cypriots and Portuguese work many hours, they do not do much in that time. The big question here is why? Is it just that they sit around and do nothing all day? I hardly think so (although many civil servants in the South are accused of doing so). The problem here lies in the heavily bureaucratic systems, with many anachronistic rules, laws and perceptions. The legal systems in Cyprus, Greece, and Italy were graded by Moody's as some of the worst in the EU, whilst Portugal's was merely average. Spain's on the other hand was very good.

This is why the South is in need of a crisis. A change in mentality and institutions is essential. Greece has only begun to realize these changes and the effect is disastrous. People are never ready to rapidly move from one mentality to another as this would mean a change of the world they live in. In the words of Olli Rehn: "And even in Greece, more has been achieved than is often realized."

This is one reason I state that change should be slower than it is now. Humans do not enjoy change. The labor force has been shown to be more resistant to change than anything else, surprisingly more than capital! (By capital one means things like machinery, plant and equipment). This reminds me the frog anecdote: If a frog is put in hot water then the frog jumps right out. If the frog is put in cold water and the water is heated slowly until it reaches the same temperature as the hot water from before, then the frog stays in and gets boiled.

The case is the same with measures: Move too rapidly and people will revolt. Take change slowly, allow people to adjust to it and you will have much better results. If you don't trust me just take a look at Greece nowadays!