Banking

The European Stability Mechanism's (ESM) bank recapitalization instrument was designed to break the vicious circle tying financially weak eurozone governments to financially weak banks. It cannot, however, actually be used until the ESM board of governors amends the ESM treaty and Germany amends its own ESM implementation law forbidding direct recapitalization. These two actions should be taken before the European Central Bank (ECB) releases the results of its important ongoing eurozone bank stress tests; failure to sequence this correctly threatens to undermine the credibility of the tests, and thereby the ECB's efforts to stimulate the resumption of the flow of credit to eurozone businesses and households. It also risks reigniting fears among investors internationally that the most heavily indebted eurozone governments may see their finances deteriorate further owing to the need to commit yet more resources to bailing out their banks. The example of the 2009 U.S. bank stress tests suggests that having adequate funds precommitted to bank recapitalization is essential to their success, and that such success is itself critical to promoting economic recovery. The Problem Eurozone policymakers are struggling simultaneously to strengthen the balance sheets of banks and governments, but each is dragging down the other: banks facing large loan losses are increasing their already outsize exposure to eurozone sovereign debt, which falls in value as fears rise that the governments will be called on to bail them out. Each is therefore weakened by financial exposure to the other. One of the chief economic challenges facing the eurozone is that action taken by the ECB to stimulate lending to the private sector is being rendered ineffective by the weak condition of the banking sector. Cheaper ECB borrowing rates for banks have encouraged them to lend more to their governments, but not to businesses and consumers. Particularly in Italy, Spain, Portugal, and Greece, the ECB is now largely powerless to lower the interest rates that matter most to economic growth. European banks have been trying to repair their balance sheets by raising capital, but uncertainty over the quality of the assets they hold makes such capital expensive. Many eurozone bank stocks trade at less than book value, which means that investors believe the banks are overstating the value of their assets. Rather than raise capital, therefore, banks have resorted to cutting back on their lending. This further weakens the eurozone economy by reducing the supply of credit available to the private sector. The ECB's Flawed Solution The ECB hopes to restore market confidence in the financial condition of eurozone banks by conducting a "comprehensive assessment," including a stress test, of 130 of the largest ones, representing 85 percent of eurozone banking assets. The strong ones will be certified, while the weak ones will be obliged to recapitalize themselves. Eurozone authorities have conducted stress tests before, but with little to show for it. In 2011, the European Banking Authority (EBA) conducted what was promoted as a stringent test of eurozone bank health. Dexia, the large Franco-Belgian lender, passed with flying colors, only to require a government bailout just a few months later. The stress test assumed much lower losses on sovereign debt in the event of a restructuring than the market and ignored the risks arising from dependence on short-term funding—both of which were factors in precipitating Dexia's downfall. In 2012, Spain conducted a much-heralded test with similarly conspicuous flaws, among which were ignoring large bank exposures to risky foreign assets (such as Portuguese debt) and assuming an "adverse scenario" in which unemployment was no worse than it was when the test was conducted. The ECB aims to do better, but its planned test suffers from another flaw that plagued both the EBA and Spanish tests: no credible mechanism to ensure that banks judged to need more capital are actually able to secure it. The Council of the European Union has laid out three steps a bank must take, in turn, to raise capital if the ECB's assessment reveals a shortfall. First, tap the private markets. Second, if more capital is needed, apply for public funds from its home-state government. Third, if a shortfall remains after the national backstop has been exhausted, seek funds from the supranational European Stability Mechanism. The ESM was established in 2012 as a permanent successor to the European Financial Stability Fund, which had been created in 2010 to address the sovereign debt crisis. The problem with this rubric is that neither national governments nor the ESM is an effective backstop for institutions unable to raise sufficient capital in private markets. Securing capital from already highly indebted national governments increases their indebtedness and makes the debt that they have issued, and that their banks hold, less valuable, thereby increasing the banks' capital shortfall. The ESM, the capital provider of last resort, is currently only permitted to recapitalize banks indirectly, through loans to national governments. This provision does nothing to rectify the problem just identified—that if a government is already highly indebted it is not in a position to recapitalize banks with yet more borrowed funds. Since bank capital shortfalls identified by the ECB may not be rectifiable through the three mechanisms available, there is, in short, no reason why the markets should be comforted by the new testing regime. Weak banks are, in fact, apt to be weakened further by being revealed as such. Since investors know that the ECB knows this, they will also put no credence in declarations that a given bank has passed its tests and is therefore adequately capitalized. The Fix The problem is, fortunately, remediable. The ESM's board of governors has agreed on the main provisions of a reform to the ESM to allow direct bank recapitalization, rather than recapitalization through the sovereign, once the ECB has assumed supervisory responsibility for eurozone banks, which should happen in November. German law implementing the ESM expressly forbids the ESM from assuming direct bank financial risk; the November 2013 coalition agreement between the German CDU/CSU and SPD parties, however, included a provision supporting the ESM making available up to 60 billion euros in funds for bank recapitalization. Amendment of the law in the Bundestag later this year, therefore, is likely. German finance minister Wolfgang Schäuble has indicated that once this amendment is made he will be in a position to vote for the necessary reforms within the ESM board. The direct recapitalization instrument was created specifically to break the link between the weak balance sheets of governments and banks—a link that the methods of capital infusion currently available only serve to reinforce. The ECB stress test results should, therefore, be published only after the ESM has been legally empowered to recapitalize eurozone banks directly with sufficient funds. The experience of the U.S. government's treatment of the country's own weakened financial system in 2008 and 2009 supports this proposal. The U.S. federal banking supervisors' stress tests of 2009 were a success—indeed, a turning point in the financial crisis—owing to the market perception that they were tough and credible. The supervisors could, critically, afford to be tough, as funds from the Troubled Asset Relief Program (TARP) were by that time available through the Capital Assistance Program (CAP) to recapitalize banks deemed to have a shortfall. There was, therefore, no reason for the supervisors to give weak banks passing grades owing to fears that failing them might spook investors and counterparties: the market knew that government funds were available as the ultimate backstop. The CAP did not, in the end, actually provide any capital to banks following the stress tests; all those deemed needing capital were able to raise it privately (with the exception of the General Motors Acceptance Corporation, or GMAC, which was recapitalized through the Automotive Industry Financing Program). Knowledge that the CAP backstop was available was instrumental in encouraging private investors to step forward; German parliamentarians should take some comfort from this. Europe cannot afford the damage to market credibility that would be occasioned by flawed ECB bank stress tests. This could trigger a cut off of market funding both to financially suspect eurozone banks and to heavily debt-burdened governments faced with unaffordable new bailout liabilities, leading to renewed fears of a eurozone breakup. It is therefore vital that these tests be conducted in the same way as the U.S. stress tests were in 2009—with sufficient public funds made available in advance to recapitalize banks that fall short.

The Issue An approach to bank regulatory reform that restricts the scope and incentives for bank balance-sheet expansion funded by short-term debt is essential to preventing another major financial crisis. Such regulation would have prevented the collapse of Bear Stearns in the United States or Northern Rock in the United Kingdom in 2008. In curious contrast, a "Volcker rule"—a ban on proprietary trading by commercial banks—would have done nothing to mitigate the worst financial crisis since the Great Depression. Yet implementing such a rule has become a domestic and international political miasma that is draining credibility from the postcrisis regulatory reform process in the United States. The effort should be abandoned. To make the U.S. banking sector more resilient and less dependent on taxpayer support, hard constraints on bank leverage should be implemented: banks should be prohibited from expanding their assets beyond a certain level without increasing shareholder common equity proportionately. To address the problem that banks find equity capital more expensive than debt, the massive incentives for debt financing in the tax code should be diluted, or preferably eliminated. The Problem With the Volcker Rule As formulated by former U.S. Federal Reserve chairman Paul Volcker, the Volcker rule is based on three beliefs: that proprietary trading is highly risky; that its economic benefits, beyond those flowing to "limited groups of highly paid employees and of stockholders," are minimal; and that institutions engaged in such activities should not have access to a federal safety net in the form of Federal Deposit Insurance Corporation (FDIC) deposit insurance and other taxpayer-subsidized props. These beliefs are defensible to differing degrees. To the extent that they do constitute compelling public policy concerns, however, the Volcker rule is not the best way to address them. It is unworkable in practice and does not speak to the fundamental problem of, or incentives driving, excessive bank risk taking. Volcker argues that banks should choose to "give up either their proprietary trading activity or their banking license," the latter of which provides them "access to the federal safety net," including government-sponsored deposit insurance. Yet one clear lesson from 2008 is that the government will on its own extend that safety net to institutions with large proprietary trading businesses in a crisis—as it did with Goldman Sachs and Morgan Stanley. If a bank is too big to fail, it will continue to attract federal supports in a crisis. The only way to eliminate such supports is to eliminate the problem of too big to fail. This requires reforms of a character wholly different from a Volcker rule. Risky Business The riskiness of proprietary trading depends entirely on the nature of the assets being traded, the trading strategy, and the leverage applied. The idea that proprietary trading is inherently riskier than traditional banking activities—transforming short-term liquid deposits into long-term illiquid loans—is surely false. The maturity mismatch between a bank's deposits (its liabilities) and traditional loans (its assets) is itself a major source of risk to its solvency, one that is much smaller when the bank's assets are liquid securities. Banking under a Volcker rule is still a risky business. Banking without a Volcker rule may be more risky or less risky, depending on the specifics of the actual proprietary activities undertaken. Volcker rightly points out that proprietary trading "is essentially speculative in nature," yet so is lending to commercial real estate ventures—a traditional banking activity. In short, proprietary risk taking is the issue to be concerned with. Proprietary trading may not involve taking much risk, and proprietary risks can be large without much trading. If a primary aim of the Volcker rule is to reduce the risk that deposit insurance funds will need to be used, a proprietary trading ban makes little sense. Policy can achieve this directly through so-called narrow banking rules—simply requiring banks to invest only in "safe" assets. The result would be the demise of credit provision by way of bank deposits, and a shift of such credit activity toward securities markets—the liquidity of which is necessarily sustained by speculative trading activity. There is no escaping this fact. The risk to depositors' funds can only be systematically reduced at the expense of lower deposit yields and less credit provision by way of bank lending. What the Volcker rule is actually getting at is not an evaluation of risk so much as a judgment on the relative societal benefits of lending versus proprietary trading. Yet the debate over the extent of legitimate carve-outs from the rule for "market making"—which has an important role in supporting the liquidity of debt markets—highlights just how blurry the boundary can be. It is thanks to securitized debt markets that many companies have been able to access cheap capital even in times when traditional banks—with impaired balance sheets from prior bad lending—have been retrenching. The present regulatory effort to distinguish acceptable market-making activities and hedging from unacceptable proprietary trading—an effort hopelessly based on divining the "intent" of a given transaction—is a recipe for inflating compliance costs and encouraging new and wasteful forms of regulatory arbitrage. Since market making is a capital-intensive—that is, relatively costly—form of liquidity provision, there is no reason why policymakers should be privileging it in the first place. Automated trading in the equity and derivatives markets, for example, can often supply market liquidity in the form of limit orders (that is, orders to buy or sell securities at a given price) at lower cost. The "intent" of the firm placing these orders is irrelevant. Such trading can also be less risky than market making. The debate over the Volcker rule has necessarily taken on a major international dimension, as it directly affects foreign institutions operating in the United States and U.S. institutions whose market-making activities support government debt markets overseas. That the Dodd-Frank Act exempted U.S. Treasury and agency debt, but not foreign debt, from the Volcker rule has naturally rankled foreign governments. They cannot understand why the U.S. government only considers market making a worthy economic activity when it is directed at its own securities. A Better Way to Ensure Financial Stability Plowing forward with the Volcker rule is not sensible. The rule does not get to the heart of the problem that fueled the financial crisis: excessive debt, particularly of the short-term variety. A direct means of addressing the risks bank behavior can pose to financial stability is limiting their leverage, which invariably rises during booms—and reverses, with enormous collateral damage, during the subsequent busts. In the run-up to the financial crisis, large banks in both the United States and Europe financed a lending surge by rapidly expanding their non-deposit liabilities—that is, borrowing short-term using tools such as overnight repurchase (repo) agreements and financial commercial paper. The explosive growth of debt securitization (like asset-backed securities, mortgage-backed securities, and collateralized debt obligations) was fueled by parallel growth in the short-term bank borrowing necessary to fund it. The United States needs to take two broad steps to constrain this process. The first is for the Fed to impose hard limits on the total assets a bank may acquire as a multiple of its common equity—what the shareholders themselves have at risk. This will restrict the ability of a bank to fund asset expansion through short-term borrowing, which increases its vulnerability to runs and sudden credit stops. This approach differs markedly from that of existing international bank capital regulation, enshrined in the so-called Basel rules, which applies an arbitrary risk weight to each of the bank's assets based on a political judgment of how risky they are—a process through which Greek government debt emerged as "risk free." The Basel approach considers reliance on funding through instruments such as reverse repos—the purchase of securities with the agreement to sell them at a higher price in the very near future—minimally risky simply because the credit risk is low. A leverage limit, in contrast, would recognize the risk to the bank's solvency inherent in the volatile funding conditions in the wider market for this sort of short-term securitized lending. Optimally, such a reform would be implemented globally, not just in the United States. American banks may complain of an unlevel playing field. But the twenty-five-year history of Basel regulation shows that implementation is so uneven across countries as to make this ambition more platonic than practical. However, Congress could take an important second step that would mitigate the banks' incentives to over-leverage in the first place: reducing the massive incentive for debt financing in the U.S. tax code. According to the Congressional Budget Office, U.S. corporations face an astounding 42-percentage-point effective tax rate penalty for equity-financed investments (36 percent) vis-à-vis debt-financed investments (-6 percent). This naturally encourages banks to operate at very high levels of leverage, and made them dangerously vulnerable financially as borrowing costs soared during the financial crisis.