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Euro Zone Says "We're Sorry!"

e21 | 12/14/2011

Of the decisions reached at last week’s euro area summit, the one with the biggest consequence was likely the decision to, in the words of Bloomberg news, “Drop Demands for Investors to Take Writeoffs in Future Bailouts.”  In the future, policymakers decided that bailouts will be full service: 100 cents on the euro, with no demand for “voluntary private sector participation.”  Since the euro crisis began in late 2009, the leaders of Germany have demanded that banks and other investors accept losses for the decision to invest in peripheral European credits at absurdly low interest rates. 

However, as the European Central Bank (ECB) has argued consistently, forcing creditors to accept losses on euro zone government debt breeds contagion.  There is no such thing as an orderly default of a member state in a currency union.  It not only ravages the banking system of the defaulting country, but also pushes up interest rates in other member states and exacerbates capital shortfalls in the entire euro zone banking system.  After months of trying it Germany’s way, the collateral damage was so severe that the euro zone leaders finally granted the ECB’s wish.   

This means that the euro zone leaders affirmatively decided to abandon any pretense about being concerned over moral hazard.  In the end, the tough talk about larger writedowns for creditors could not survive the basic economic reality that the larger the expected losses, the greater the interest rate compensation demanded by creditors.  And the higher the interest rates demanded, the worse the solvency situation looks because interest payments consume a larger share of tax revenue.  If the 50% writedown on Greek debt were applied to Italy, investor losses on the current stock of Italian government debt would be in the neighborhood of €950 billion.  Given the share of Italian government debt held by the banking system, a writedown of this magnitude would have been tantamount to a European banking crisis several orders of magnitude greater than what the U.S. experienced in 2008.  As attractive as “private sector involvement” may seem in theory, in practice it turned out to intensify the crisis.  

This is an important lesson for U.S. observers wondering how Dodd-Frank is likely to impact future bailouts.  While Dodd-Frank’s “resolution authority” grants regulators the power to assume control of an insolvent bank and inflict losses on creditors, it does not give those regulators a magic wand that can minimize the economic impact of those losses.  As demonstrated by the euro area crisis, just because the government has the power to assign losses doesn’t mean the private sector has the capacity to withstand them.  If regulators (principally the FDIC) were to use Dodd-Frank to inflict large losses on thinly-capitalized creditors to an insolvent bank, the effect would be the same as in Europe: (1) investors would demand a large and growing premium to lend to all institutions similarly situated to the insolvent bank; and (2) the losses would likely trigger a new round of insolvencies as creditors recognize the credit losses from the insolvent bank and the new fair value losses on their holdings of similarly-situated bank obligations.  

Could the euro zone have avoided this outcome?  Probably.  But it most likely would have required forcing financial institutions to issue hundreds of billions of euros of fresh equity capital.  The vulnerability of the financial system to losses is a negative (exponential) function of equity capital levels.  Let’s say banks financed 14% of their assets with common equity (7-to-1 leverage ratio). If that were the case, assessing the scale of losses in Europe would involve heartache, but not a systemic meltdown.  Yet, equity capital ratios of that size greatly reduce returns on equity, the key metric for bank valuations.  Imagine a bank that earns 1% per year in net income on $10 billion in assets.  If it holds just 3% capital, the return on common equity is 33%.  By contrast, if it holds 14%, the same portfolio of assets generates a return on equity of just 7.14%.  For a bank manager whose compensation is based on shareholder expectations of an ROE in the teens, this can be the difference between a blow-out year and a pink slip. 

Indeed, many institutions can safely operate with existing capital standards.  The problem is that it’s practically impossible to know which ones they are beforehand – especially since many bank balance sheets continue to be very opaque.  As a result, policymakers seemingly must choose between one of three options: (1) higher capital standards; (2) suffocating levels of regulation to guard against excessive risk-taking; or (3) a fragile financial system susceptible to crisis.  

Of all of the regulations put in place during the Great Depression, perhaps the most significant was Regulation T, which gives the Fed the authority to determine the initial margin brokers-dealers can extend on a security purchase.  For example, a 50% margin means that a purchaser with $100 cash could purchase securities with a maximum value of $200.  The limitation on leverage is liberating: by deciding how assets can be financed, regulators can remain agnostic with respect to the assets the investor buys.  The same logic can be applied to banks through higher capital standards.  Were banks – especially large institutions – required to hold more capital, regulators could spend much less time worrying about what kinds of loans the banks made.  Although one could argue that more capital would simply encourage banks to assume even greater risk, empirical evidence makes clear that the main risk is too little capital.  Five years ago, it was reasonable to think banks should hold very little capital against AAA government bonds, yet today these are the very instruments at the heart of the crisis.  

Since the euro area crisis is principally about governments and their liquidity problems, there is a tendency to view the problems solely as a fiscal problem.  But the “too big to fail” sovereign borrowers generate the same problems as “too big to fail” banks for an overleveraged and undercapitalized banking system.  Should the crisis intensify in Europe, American banks would likely suffer extreme losses, largely due to counterparty and wholesale funding risk.  While many in the U.S. would try and lay the blame on Europe and its leaders for letting such an event occur, it’s impossible to ignore the opportunity that was presented in 2009 to achieve meaningful domestic prudential reforms and system safeguards – and then the inadequate results from the enactment of Dodd-Frank (a.k.a. the Wall Street Reform and Consumer Protection Act) in the early summer of 2010. Put simply, it’s not easy to find analysts who think the U.S. is as prepared as it should be today.