Madame Lagarde should be pleased with her participation at the Jackson Hole conference this year. With her speech last Sunday, she achieved two important goals.
First, by calling European politicians to task, she established her independence and silenced those who thought that she might find it difficult to represent all member countries of the International Monetary Fund or to deal objectively with Europe ’s financial problems.
No doubt the US, which would end up being the lender of last resort if the EU were to collapse, were pleased with her call for action. So were many emerging countries which, some years ago, were subjected to tough medicine when their economies and public finances spun out of control.
Second, she said aloud what some would only murmur in private, and she went to the heart of the current malaise in European financial markets. Already, several European governments and even the ECB are pooh-poohing her recommendations. That may be an understandable emotional reaction, but the fact is that pressure for action has been raised a few notches and markets will not fail to “misbehave” if nothing is done.
What Madame Lagarde said was that weakly capitalized banks contributed to the financial problems of Europe because they were viewed as carrying too little capital and therefore vulnerable to country restructurings. The resulting lack of confidence in bank counterparty risks reduced market liquidity and thus propagated sovereign crises well beyond their borders. Therefore, said Mme Lagarde, European banks needed to raise capital, preferably from private sources, but also from public sources if need be.
Comparing European banks with US banks, it is obvious that the latter are less well capitalized than the former. US
By contrast, the last two European stress tests have failed to inspire investor confidence, and rightly so. European banks, by and large, carry less capital, have less generous loan loss provisions and enjoy lower levels of deposit funding. Most crucially, these stress tests didn’t really show what happens if some countries restructured; it may be understandable that Europeans did not want to trigger self-fulfilling prophecies, but markets had no such compunctions, and they didn’t like what they saw.
It is therefore evident that many European banks must be strengthened. The ECB and others say that they stand ready to provide liquidity, but they do that in a highly inefficient way, and, depending on the scenarios, they may not have enough money. Mme Lagarde’s prescription, which is along the lines of the US TARP, is better.
If a large deposit bank carries a conservative debt leverage of 10:1, it is very obvious that providing it with €1 of equity will allow it to raise €10 of debt in the interbank or other debt market. This is a lot more efficient than lending it €10. If its leverage is higher, the gains in efficiency are even greater.
The problem is that banks have been demonized, and capital has been presented by governments and some regulators as shackles to prevent another meltdown rather than a base from which to make good, profitable, loans. This is hardly the kind of “atmosphere” that will entice investors to pay a fair price to subscribe fresh bank capital. In truth, US banks had it easier in 2009 because the anti-bank movement and Dodd-Frank had yet to gather full momentum.
Be it as it may, many European banks need more capital, and if European governments do not want to become big bank shareholders, they need to tone down the rhetoric and be more realistic about bank regulations. Should public capital be needed, using the European Financial Stability Facility (also called the €440 billion bail out fund) would indeed be a good idea. It would introduce an element of objectivity, providing a regional pwespective and improving the chances that all banks would be treated equally.
Mme Lagarde’s first act was a success. More will be expected from her as the European problems are difficult and of a size that will pull the whole world into their solutions.
