Open Letter to European leaders on Europe’s banking crisis: A call to action

This is a once-in-a-lifetime crisis. Trust among financial institutions is disappearing; fear may spread. Last week’s US experience showed that saving one bank at a time won’t work. A systemic response is needed and in Europe this means an EU-led initiative to recapitalise the banking sector. Unless European leaders immediately unite to address this crisis before it spirals out of control, they may find themselves fighting over how best to salvage the aftermath.

Europe is in the midst of a once-in-a-lifetime crisis. Every European knows what happened when financial markets seized up in the dark years of the 1930s. It is not an exaggeration to say that it could happen again if governments fail to act. We are not predicting that it will happen, but it is critical to know that this is what is at stake.Trust among financial institutions is disappearing and there are risks that fear will spread more widely. Turmoil in financial markets must be stopped before it causes major damage to the real economy. The savings of hundreds of millions of Europeans are directly threatened. If the turmoil produces credit market paralysis, jobs and businesses will be destroyed on a massive scale. A further weakening of the real economy would put more loans at risk and create a vicious cycle of falling asset prices, deteriorating ability to repay loans, and diminishing credit flows.Actions by US policymakers are welcome, but they are not sufficient. Decisive policy action is required in Europe as well.

Policy spillovers: European-level actions to supplement and coordinate national actions

The US authorities learned last week that saving one bank at a time won’t work; a systemic crisis demands a systemic response.

In Europe, saving one bank at a time means either a rescue effort mounted by one nation, despite important spillovers to neighbouring countries, or last-minute improvised coordination and agreement about fiscal burden sharing. The national responses and ad-hoc cooperative efforts to date have been useful. Yet interdependence among European banks is too deep and too wide-spread for national responses or case-by-case coordination to be enough. Each national policy intervention and each cooperative intervention by a small number of countries can have unpredictable implications for other European nations. It is critical that national authorities sit together and coordinate their responses, developing Europe-wide solutions where appropriate.

Now is the time to act while the situation still appears manageable. Last week’s events in the US demonstrate that financial crises do not evolve smoothly and predictably. One unexpected event can trigger a cascade of failures and panics that become increasingly difficult to control.

Solutions

Many solutions will be part of the answer. In the US, dealing with the immediate crisis requires restoring liquidity to money and credit markets, and creating the conditions for the resumption of the securitisation of prime mortgages and other illiquid but sufficiently homogeneous and transparent assets. In Europe, the key problem is high leverage among the internationally active large banks. Hence the EU contribution must be centred on a recapitalisation of the banking sector, through the injection of public equity or through mandatory debt-to-equity conversions. This has to be done at the EU level (e.g. through the EIB). The current approach of rescuing one institution after another with national funds will lead to a Balkanisation of the European banking sector. Agreeing a harmonised level for deposit insurance would also be important.

To prevent future crises of this nature, regulation of the European financial markets and institutions at the European level will also be required.

The problem is not a lack of understanding of how to stop financial crises. The problem is a lack of political will.

Unless European leaders immediately unite to address this crisis before it spirals out of control, they may find themselves fighting over how best to salvage the aftermath.


Originally published at VOXEU and reproduced here with the author’s permission.

3 Responses to "Open Letter to European leaders on Europe’s banking crisis: A call to action"

  1. erikwim   October 6, 2008 at 4:51 pm

    It is an illusion that systemic risk can be reduced by having a central european regulator. On the contrary sytemic risk will be increased. even if the single regulator would do a better job at regulating, which is not at all obvious, it would still icrease systemic risk especially the risk of a catastrphic blow-up. Since if the single central regulator fails to do a proper job that is teh end of it. Also there is much less learning and experimenting. I would like to reccommend Jared Diamond in this respect and his analysis of failed societies. ‘Competing’ regulators with smaller jurisdictions will in most cases do a much better job. The proof for my point is probably exactly the current crisis. The US has a central regulator and lender of last resort. Both institutions actually fueled the current crisis. The fed by helping to provide the cheap money to blow up teh bubbel, the regulators by not regulating and the lawmakers by not creating new regulation. My guess is that Europe as a whole will fare much better in this crisis and that there is a much smaller probability that a similar size crisis could be created in Europe as long as we keep our potpouri of central banks and regulators.

  2. Ezio Pacchiardo   October 10, 2008 at 8:31 am

    Some considerations on the present crisis.If the crisis we fall into is due to the financial economy and not to the real economy, then we must control the first one, this being driven by the “managers” and in part from the entrepreneurs. So far we must disincentive the manager and the entrepreneurs by bubbling up the financial figures of the company they work for. That is to keep these managers operations more tight to the real economy of the company they are leading. One possible way to avoid these managers by doing just bubble financial operations is to fix for them, by financial regulation, a ceiling salary, and to recognize it, up to that ceiling, as a company opex in the taxation statement; any salary over that limit is to be considered and taxed as profit for the company and subject to overtaxation for the managers. Furthermore we must disincentive the financial game that is any financial operation is allowed only if endorsed by a percentage in real liquidity, let us say 70% so that the risk will be limited to the remaining 30%; being these percentages managed and changeable by the Government depending on the world wide global economy status, the growth perspective and the country strategy. Again the real problem is to keep the financial economy as tight as possible to the real one if we don’t want to fall into another crisis. But unfortunately the human being is more oriented to run risks and fix the problems as they occur rather than to do some reasonable planning, that since Adam and Eva as far as I can understand.

  3. I. von Pless   March 16, 2009 at 3:24 pm

    This G. guy is a perfect eample of the bright idiot (We have lots of them in France thanks to the mandarinal system of selection of the local version of the nomenklatura called énarchie). I wrote on a blog mid 2005 that he should worry a bit more about the loose practices of bankers and mortgage peddlers, instead of basking under the spotlights of TV studios.It is certainly true that the disinflation and lowering of inflationary expectations owes a lot to the policies adopted by most developed countries since the mid-80s – independance of central banks, inflation targeting -. But Bernanke explained the low yield of long term bonds also by the “global savings glut”. Keynes was obviously not fashionable during those happy years of Goldilockonomy. So the low yields were due to all those Chinese saving to much and buying Tbonds. As a matter of fact (Trade and Development Report 2007, UNCTAD), the household saving rate was about 16%, China was investing a huge 40% of GDP, and the savings glut was for the most part the cash flow of very profitable businesses. Add to that a considerable inflow of FDI, thus China had to export hundreds of billions on the capital account. But why did they buy all these Tbonds instead of diversifying their reserves?This question is so stupid that I won’t bother answering it.However there’s an other twist in the story, and there Greenspan is right, inflation does not depend only on monetary policy but also on competition, and globalisation has had a dramatic effect on the prices of tradable manufactures AND put a lid on wages and employment in developped countries. And here is the conundrum. How can consumer who’s income decrease buy an ever growing glut of unnecessary but so tempting and cheap goods?Only if an asset bubble makes it possible to increase their debt evermore.