VoxEU: Stop coddling Europe's banks

11 January 2012

Throughout the European debt soap opera, Europe's leaders have expressed their willingness to “do whatever it takes” to restore stability and save the euro. This column argues that, too often, policymakers have in fact been “doing whatever it takes” to serve the banks.

After initial denials, Europe’s leaders have started to acknowledge that IMF Chief, Christine Lagarde, was right. Through their statements and decisions, policymakers are showing their agreement with her assessment in August 2011 at the Federal Reserve’s Jackson Hole symposium that there was an urgent need for recapitalisation of Europe’s banks.

This recognition of reality is the good news. The bad news is the EU’s bank recapitalisation is being handled in a way that will make a recovery from Europe’s debt crisis more problematic than it needs to be. There are five concerns:

  1. incentives for deleveraging;
  2. absence of firm guidelines on dividends and executive compensation;
  3. omissions of a recession scenario and of an unweighted leverage ratio from the stress tests;
  4. inequitable burden-sharing during debt restructuring; and
  5. insufficient measures to permit an escape from the adverse feedback loop between sovereign debt and bank debt.

Pro-cyclical deleveraging
First, by specifying the new bank capitalisation target (a 9 per cent Core Tier ratio) as a ratio to risk-weighted assets rather than converting that ratio into a target for increases in bank capital alone, the European Banking Authority (EBA) has increased the risk of a pro-cyclical response in a region where economic growth is fragile and weakening further.

Dividends and executive compensation
A second misjudgement was not to announce simultaneously (with the higher bank capital target) a firm EU-wide policy on bank dividends and compensation. The December 2011 EBA recommendation advises banks to tap private-sector sources of finance first for recapitalisation, but stops well short of issuing any firm guidelines on either dividends or compensation.

Weakness of the stress test
Yet a third concern has to do with remaining weaknesses in the bank stress tests conducted by the EBA – weaknesses that are contributing to uncertainty about the creditworthiness of EU bank counterparties and that also partially explain why eurozone banks have made record cash placements with ECB Deposit Facility.

Burden-sharing during debt restructuring
Concern number four is with equitable burden-sharing during sovereign debt restructuring. At its 9 December 2011 meeting, the European Council decided to reverse its earlier position on private-sector involvement; it announced that private-sector burden-sharing would no longer be required beyond the restructuring of Greek sovereign debt.

The sovereign and bank debt tangle
Last but not least, there is the broader concern of how the eurozone can escape the adverse feedback loop – operating in both directions between sovereign debt and bank debt.


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