One of the benefits to European policymakers of Brexit is that it has dominated news coverage for months, diverting attention from several indicators that the banking crisis in Europe is inexorably worsening.
When Italy announced, a few days after the Brexit vote, that it was preparing a €40 bn government recapitalisation of its banking system, Rahm Emanuel’s observation, “You never let a serious crisis go to waste” sprung to mind. Prime Minister Renzi’s proposal was notable because it contravenes the EU’s banking union rules obliging all creditors, including unguaranteed depositors, to be ‘bailed in’ before the question of public funds is supposed to arise. It is difficult to see a connection between the UK’s declaration of preference for self-government and the dramatic drops in bank share prices on the Rome bourse; but senior Italian bankers had no such difficulty. They are sitting on €360 bn of non-performing loans, equivalent to about 18% of total assets and more than 100% of reported bank capital.
Prime Minister Renzi is so concerned, that he has sounded out his German counterpart about his aspiration for a temporary suspension of the creditor bail-in rules, but without success. After Mrs Merkel rebuffed him, he parried with a barely veiled attack on Deutsche Bank, recently labelled the greatest systemic threat to the global financial system by the IMF. To emphasise that the “derivatives problem” within Europe’s big banks dwarfs the problems of Italian banks, Mr Renzi used some numbers:
„If this non-performing loan problem is worth one, the question of derivatives at other banks, at big banks, is worth one hundred. This is the ratio: one to one hundred.“
Returning to Brexit, are we Brits smiling smugly that our banks are in much better shape? Well, given the Bank of England’s actions in early July, the answer should be a decisive “no”. On July 5th Governor Mark Carney announced that, as a policy response to jittery post Brexit UK financial market indices, the UK’s central bank was increasing UK banks’ maximum permitted leverage – in other words increasing the amount of debt by which loans and other assets could be funded. In the Alice in Wonderland world of banking regulation this is spun as a boost to British banking, as “freeing up” cash for lending to the “wider economy”. Let us analyse this.
As confidence in the integrity of the accounting profession’s application of IFRS rules to banks has waned, creditors, public scrutineers and customers increasingly have become reliant on central banks for information as to which banks are ‘safe’ or ‘in trouble’. The primary measurement tool of banks is to measure the exposures of banks, adjusted for central banks’ assessments of riskiness, and compare this figure with each bank’s capital base. In order for a bank to be adjudged safe its actual capital base must exceed a minimum. The minimum is composed of four components, one of which was, for all UK banks prior to July 5th, a “counter-cyclical buffer” of 0.5%. The Bank of England reduced this to zero on July 5th, claiming that the £5.7 billion system wide reduction in capital triggered by this decision will help banks increase lending to businesses and consumers by £150 billion. But this interpretation is pure spin. Banks throughout Europe are awash with cash, even as they teeter on the cusp of insolvency. The UK is no different, which is why policies have been introduced to deter banks from parking spare cash with their central bank. More importantly, how can it help the UK economy to encourage banks to re-leverage themselves to the greatest extent permitted by the rules, having clearly bent these rules? If there was any credibility to the 4 component capital metric, and the Bank of England had acted prudently and properly by imposing a 0.5% countercyclical buffer, to remove it abruptly when the risks to the economy have supposedly increased, shatters that credibility.
Furthermore, the mainstream media which have broadly supported central bank responses to the banking crisis these past 9 years are now willing to call out such actions for what they are: [https://www.bloomberg.com/view/articles/2016-07-08/the-bank-of-england-makes-a-capital-mistake]. They know that this announcement is a sign that things are far worse than regulators claim.
What lessons should Bulgaria take away from this powerful evidence that the bailouts of large, private banks by the UK, Germany and Italy have not worked? Nor is the problem confined to them. Spain’s banking system has an estimated €129 bn exposure to non-performing loans, Austria’s richest province, Carinthia, is still bleeding over the failure of Hypo Alpe Adria, to say nothing of Greece. How is this likely to play out? We need look no further than Japan, which has been propping up its broken banking system for 25 years with an array of monetary stimuli.
Serious commentators such as Lombard Street Research now consider Japan’s position to be virtually hopeless. According to LSR, influencing the value of the yen is now “beyond the reach” of the Bank of Japan; QE has reached the end of its effectiveness; the failure to engage two weeks ago in “helicopter money” amounts to applying a sticking plaster to the economy. For those unfamiliar with the term, “helicopter money” is QE without the asset purchases, ie the naked printing of money and transfer to the government or at the government’s direction, possibly to households. This imbalances the balance sheet of the central bank itself, and has not yet been deployed by any major central bank for fear of triggering a crisis of confidence in the currency itself. Although it might appear odd, given the global environment of near zero interest rates, LSR is not alone in contemplating that these policies might sooner rather than later lead to hyperinflation.
Surely the message is not to bail out any failed banks, but wind them up and send a message that insolvent banks will not be tolerated. However, if policymakers feel there is an overpowering case to apply moderate public funds to a particularly important bank, it should be nationalised. This would enable new independent management to report to the government and the public as to the true state of affairs and whether turnaround measures can be implemented to permit a re-flotation.
Of course the debate within Bulgaria as to whether to join the Eurozone rages. My view is that Bulgaria should stay exactly where it is. Not only is the Eurozone once again in choppy waters with the Italian banking crisis, but the EU itself is regarded as unsustainable by US ratings agency S&P. Echoing the views of almost everyone, they see the EU only surviving either by greater political integration or via substantial relaxation of political ties, reverting to the kind of customs union format which would have appealed to most Brexit supporting Brits.
By maintaining its unique status as in the EU and attached to the currency only by the Currency Board, Bulgaria is in a good position to make contingency plans which could be far more easily implemented than the UK’s Brexit. It would surely be a mistake to get sucked closer in now, either by joining the Eurozone or by copying failed banking policies of bailing out private banks.
 Northern Rock failed Sept 07