The US financial system is being nationalised. The piecemeal approach followed so far had clearly not been working. Hence the US political system is working overtime to reach a bipartisan agreement on a systemic solution. The centrepiece is already known: the US government is going to buy $700bn (€480bn, £380bn) of the so-called “toxic” assets. More measures are certain to follow as the banks will require recapitalisation to the extent that they make losses. As a result, the US government will soon own a large share of the US banking system. If the details are generous enough, this should be sufficient finally to restore orderly market conditions. Can Europe be far behind?The synchronised movements in global markets over the last few weeks have shown that contagion works on the way down and on the way up.
But the case of AIG, the US insurer, also shows the importance of another, hidden, link across financial markets, namely massive evasion of regulatory requirements. AIG’s last annual report reveals that it had written coverage for more than $300bn of credit insurance for European banks. The comment by AIG itself on these positions was that they were “for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee”. Thus, a formal default by AIG would have exposed European banks to large increases in regulatory capital requirements, with possibly devastating effects on their ratings and market confidence. Thus, the US Treasury has saved, inter alia, the European banking system.
The extent of regulatory arbitrage can also be seen in the very large gap between overall leverage ratios and the official regulatory ratios. The dozen largest European banks have now, on average, an overall leverage ratio (shareholders’ equity to total assets) of 35, which has actually increased so far this year, compared with less than 20 for the largest US banks. But at the same time most large European banks also report regulatory leverage ratios of close to 10. This is partly due to the fact that the massive in-house investment banking operations of European banks are subject only to limited regulatory capital requirements. Another part of the explanation must be regulatory arbitrage, for example, through the credit insurance offered by AIG.
Europe’s banks will benefit greatly from the effective nationalisation of the US financial system now being planned, because the larger ones, which all have significant US operations will also benefit from the $700bn bail-out fund. But it remains unclear how many of these assets they still hold in their balance sheets and how volatile their liability base will prove if confidence does not return quickly.
The crucial problem on this side of the Atlantic is that the largest European banks have become not only too big to fail, but also too big to be saved. For example, the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to about €2,000bn (more than Fannie Mae) or more than 80 per cent of the gross domestic product of Germany. This is simply too much for the Bundesbank or even the German state, given that the German budget is bound by the rules of the European Union’s stability pact and the German government cannot order (unlike the US Treasury) its central bank to issue more currency. Similarly, the total liabilities of Barclays of around £1,300bn (leverage ratio 60!) are roughly equivalent to the GDP of the UK. Fortis bank has a leverage ratio of “only” 33, but its liabilities are three times the GDP of its home country of Belgium.
With banks that have outgrown their home turf, national treasuries and regulators in Europe are living on borrowed time: they cannot simply develop “road maps” (the only result of various Ecofin discussions of regulatory reform by finance ministers), but must contemplate a worst-case scenario.
Given that solutions for the largest institutions can no longer be found at the national level it is apparent that the European Central Bank will need to be put in charge as it is the only institution that can issue unlimited amounts of a global reserve currency. The authorities in the UK and Switzerland – which cannot rely on the ECB – can only pray that no accident happens to the giants they have in their own garden.
Originally published at Financial Times and reproduced here with the author’s permission.