Systemic bank crises are always difficult to resolve. In Europe, the difficulty is compounded by cross-border interdependencies. Policy paralysis throughout 2009 and 2010 has resulted in a banking system precariousness that puts a serious drag on the old continent’s recovery. An even more dramatic consequence is to force the Eurozone to systematically choose bailouts over restructurings, whenever one of its members faces macroeconomic difficulties.

• In April, there was a strong case for immediate sovereign debt restructuring rather than saddling Greece with unsustainable debt levels.

But the resulting shockwaves might have toppled fragile Western European banks and gone out of control. Greece’s bailout was chosen as the least bad option.

• In November, many voices similarly called for imposing losses on Irish banks’ senior debt (O’Rourke 2010).

But this might have impaired the ability to borrow for European banks whose balance-sheet strength is questionable, possibly causing a panic. Thus, bailing out senior bank debt was a big part of the Irish assistance package.

Those decisions may have been inevitable in their respective circumstances, but their outcome is gross unfairness. Moreover, they have accelerated the debate on Eurozone solidarity and fiscal federalism – a debate for which the EU may not be politically ready. The major policy failure has been the absence of firm action in calmer times to make the system more resilient.

Such action to solve the present crisis cannot be replaced by decisions on how to manage future ones, such as at the Treaty amendment agreed by the European Council meeting of 16-17 December.

Systemic bank crises don’t fix themselves

Systemic banking crises are almost never self-correcting. Even with low central-bank rates, retained earnings cannot plug all holes after a major shock. What is needed is a government-led process of ruthless triage, recapitalisation, and restructuring of the system’s most important banks.

This approach was pursued by:

• the US in 1989-90 following the savings-and-loan crisis,
• Sweden in 1992-93,
• Japan in 2002-03, and
• the US with its 2009 stress tests.

The EU has not yet done anything comparable.

• A first round of Europe-wide stress tests in September 2009 went virtually unnoticed as the results were not made public.
•  A much-hyped second round included public disclosures in July 2010 (CEBS 2010), but ultimately failed to restore confidence.
• A third round is forthcoming in February 2011.

European Commissioner Olli Rehn announced it will be “even more rigorous and even more comprehensive.” But the design flaws of the previous attempts must first be fixed for this to succeed.

History suggests three components of the next stress test are essential.

• Triage: A public assessment of the real capital position of all important institutions in the system.

This must be based on an intrusive, uniformly stringent review of assets and liabilities – financial statements are unreliable in crisis times.

Large cross-border financial linkages mean that the test must be Europe-wide. Last July, triage failed when each member state implemented the commonly defined methodology its own way.

As national authorities cannot be trusted to place the EU common interest before their own, a central body must be empowered to double-check national assessments and make sure they are genuinely comparable.

• Recapitalisation: Banks that have been found too weak must raise new capital.

As last time, the next stress tests’ public results are likely to underestimate capital gaps, because EU policymakers cannot explicitly include sovereign default in a stress scenario for fear of this assumption becoming self-fulfilling.

To compensate for this unavoidable flaw, policymakers should toughen other stress assumptions and impose a high threshold of a strict measure of capital, rather than the loosely defined “Tier-1” tested last July (Alloway 2010). They must add extensive disclosure of each institution’s sovereign risk exposure, with better explanation than in July of how to reconcile such numbers with otherwise published financial statements and with the Bank for International Settlements’ statistics (Enrich 2010).

• Restructuring: Some banks may fail to raise the needed capital.

Such banks must be either forcibly sold, or dismantled in an orderly way. This process must also be steered centrally to ensure fairness and efficiency. Potential difficulties are many.

Banks that are widely seen as “national champions” may be acquired by foreign competitors. Jobs may be destroyed, in the banks and also in the non-financial companies they support. National authorities may be pilloried for their past failures to act and their links to failed financial elites.

New legislation may be needed, with all the related uncertainties. Specifically, the newly created European Banking Authority may not have what it takes for such a tough job, and it might be preferable to create a temporary body specifically dedicated to crisis resolution (Posen and Véron 2009). Public funds may have to be committed in significant amounts, to meet legal obligations and avoid dangerous contagion. Negotiations may be needed on sharing the burden among countries, and on possible cross-border assistance as in the Irish case.

Conclusion

All this can be very disruptive. But the alternative is a policy process held hostage by a sick banking system, and ever larger commitments of taxpayers’ money that may threaten the very political fabric of the EU.

References

Alloway, Tracy (2010), “Building a better European stress test”, FT Alphaville, 7 December CEBS (2010), “Press Release on the Results of the 2010 EU-wide Stress Testing Exercise”, Committee of European Banking Supervisors, 23 July Enrich, David (2010), “Europe’s Bank Stress Tests Minimized Debt Risk”, Wall Street Journal, 7 September O’Rourke, Kevin (2010), “Barry Eichengreen on the Irish bailout”, The Irish Economy, 1 December Posen, Adam and Nicolas Véron (2009), “European banking needs a state-led triage body”, Financial Times, 3 July