04 October 2012

Stefan Collignon: The bankruptcy of the no-bailout principle

There is a lot of evidence that the euro debt crisis is a liquidity crisis. Even in Greece public debt was sustainable before the credit crunch and fundamentalist austerity policies converted the global financial crisis into a five-year depression. However, a particular feature of the euro crisis is due to the home bias in banks’ asset portfolios. Home bias means that local banks hold excessive shares of “their” government’s debt in their portfolio. The reason is that often national governments use local banks like house-banks to meet their funding requirements. The drawback is that banks with home bias in their asset portfolio are excessively vulnerable when yields on the national debt increase and prices collapse because it weakens their balance sheets. With home bias, local banks will suffer disproportionately from the deterioration of local economic conditions.

Hence, if markets punish excessive borrowers by pushing up rates, bond prices will fall. This is exactly what the market discipline theory seeks to achieve. But as a consequence, the assets of banks and other private investors will depreciate. This fact turns the no-bailout clause into a dangerous policy principle, especially when it is combined with home bias. To restore their balance sheets, local banks will reduce leverage, sell the depreciating governments bonds, and stop lending. In short, they will cause a credit crunch; alternatively, they will lend aggressively to high-yielding risky projects, thereby increasing financial fragility. Either way, the principle of no-bailout will destabilise the euro area and damage growth and employment.

Unfortunately, the no-bailout principle overlooked this logic because it ignored external effects. If it had been valid, a rise in government bond yields would not have affected the borrowing conditions for other debtors within a given Member State. But this is not what we have observed. In fact, a salient feature of the euro area crisis is the strong interdependence between the banking and sovereign crisis.

Hence, the theory of creating market discipline by the no-bailout commitment is bankrupt, and the European Central Bank has now become its receiver. The ECB has to pump liquidity into financial markets and buy up securities from extremely fragile sovereign debtors, because governments refused to stabilise the euro economy in the early stage of the crisis. The OMT pose potential risks for the ECB’s balance sheet in the medium term, because the bank disproportionally accumulates risky securities.

These risks could have been avoided had governments cooperated instead of dogmatically insisting on a mistaken concept, namely the no-bailout principle. The EMS would have been the proper vehicle to generate a stabilising bailout under democratic control. A proper banking union and the swap of national debt into eurobonds could have reduced the effects of home bias. But governments have blocked this route. Thus, while the ECB does whatever it takes to save the euro, sovereign nation states are the root of all evil.

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