The beginning of the end game…

Daniel Gros, Stefano Micossi

The radical moves in the US have direct implications for European banks and indirect implications for European governments. This column discusses the likely channels and notes that several European banks are both too big to fail and may be too big to be saved by their national governments alone.

The US financial system is being nationalised. The piecemeal approach which culminated with the AIG operation was clearly not working. The US government had taken control of its biggest insurance company just two weeks after it had to save Fannie and Freddie, by far the world’s largest mortgage underwriters. All this was not enough to restore orderly market conditions, hence the US political system is working over time to find a general solution whose outline is already apparent. The US government is going to buy the so-called "toxic" assets still on the banks' balances and will then recapitalise the banks to the extent that they make losses. As a result, it will soon own a large share of its own banking system. If the details are generous enough, this will finally be enough to restore orderly market conditions. It is not going to be the end of the story, as it is likely that a number of medium-sized regional banks heavily exposed to the real estate market (through mortgages, not "toxic assets") will soon have to be saved as well.

It is fitting that the first institutions to be formally nationalised in this crisis were not banks in the traditional sense, but institutions (Fannie and Freddie, AIG) that were supposed to play only a supporting role in the financial system.

The AIG operation: "Haircut" without the hair

Formally, the AIG operation is composed of two separate elements:

The Federal Reserve of New York has been “authorised to lend” AIG up to US$ 85 billion, and

The US Treasury is taking control of AIG, of which it will own 80%, thereby immediately changing its management.

The Federal Reserve is thus providing financing to the US government. The punitive terms (850 bps above LIBOR) agreed for the loan to AIG are irrelevant as any interest payments would merely go from the left to the right hand pocket of the government.

Fed independence and the recapitalisation by the Treasury

But at the same time the balance sheet of the Federal Reserve has now been loaded with so many assets of dubious value that the Fed itself may soon no longer be solvent; hence the Fed’s request for a recapitalisation by the Treasury. This means that the US Central Bank has lost its independence, since it now survives on a life-line from the US government.

An independent central bank committed only to the goal of price stability used to be considered an essential cornerstone of a modern macroeconomic stability-oriented policy framework. In the US, this is giving way to a situation in which the central bank has ended up in the pockets of the finance ministry as a consequence of its frantic efforts to re-establish normal operating conditions in financial markets. In all likelihood, the large increase in US government debt under way will be matched by increased monetary financing of the deficit.

Will Europe be far behind?

Links between global financial markets

Global contagion works on the way down and up. The near miss of AIG, followed closely by the mother of all bailouts now planned in the US, provides a vivid illustration of the nature of the links between global financial markets. One key link has been risk-sharing. European (and other) financial institutions held a large share of the assets based on US residential mortgages and thus shared in the losses that arose when the US housing market turned sour. This type of risk-sharing is exactly what financial globalisation should be able to provide. The US banking system would be in an even worse shape had all the losses from US sub prime-based securities been concentrated in the US.

AIG's impact on European bank’s regulatory capital

But the AIG case shows the importance of another link across financial markets, namely massive circumvention of regulatory requirements. The K-10 annex of AIG’s last annual report reveals that AIG had written coverage for over US$ 300 billion of credit insurance for European banks. The comment by AIG itself on these positions is:

“…. for the purpose of providing them {European Banks} with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee”.

Thus, a formal default of AIG would have exposed European banks’ large gap of regulatory capital, with possibly devastating effects on their ratings and market confidence. Which explains why AIG’s problems had sent shock waves through the share prices of European banks. Thus, the US Treasury has saved, inter alia, the European banking system. However, as AIG is to be liquidated, European banks will have to quickly shore up their regulatory capital.

The extent of regulatory arbitrage can also be seen in the very large gap between overall leverage ratios and the official, regulatory ratios. The dozen largest European banks have now on average an overall leverage ratio (shareholder equity to total assets) of 35, compared to less than 20 for the largest US banks. But at the same time most large European banks also report regulatory leverage ratios of close to 10. Part of the difference is explained by the fact that the massive in-house investment banking operations of European banks are not subject to any regulatory capital requirement. Another part of the explanation must the regulatory arbitrage, for example though the credit insurance offered for example by AIG.

Positive spillovers for Europe’s banks

Europe’s banks will benefit greatly from the wholesale effective nationalisation of the US financial system now being planed because the prices of the so-called "toxic" assets will be stabilised. But it remains unclear how many of them they hold in their balance sheets and how volatile their liability base will prove if confidence does not return quickly. And the ECB is already overloaded with assets of dubious quality in gigantic amounts.

Too big to fail and too big to save?

The key problem on this side of the Atlantic is that the largest European banks have become not only too big to fail but also too big to be saved. For example, the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to around 2,000 billion euro, (more than Fannie Mai) or over 80 % of the GDP of Germany. This is simply too much for the Bundesbank or even the German state to contemplate, given that the German budget is bound by the rules of the Stability pact and the German government cannot order (unlike the US Treasury) its central bank to issue more currency. The total liabilities of Barclays of around 1,300 billion pounds (leverage ratio over 60!) surpasses Britain’s GDP. Fortis bank, which has been in the news recently, has a leverage ratio of "only" 33, but its liabilities are several times larger than the GDP of its home country (Belgium).

Are European regulators living on borrowed time?

With banks that have outgrown national regulators and the financing capacities of national treasuries, European central banks and regulators are living on borrowed time. They cannot simply develop “road maps” but must contemplate a worst case scenario.

The ECB must be in charge; Britain and Switzerland should pray

Given that solutions for the largest institutions can no lounger be found at the national level, it is apparent that the ECB will need to be put in charge. It is the only institution in the euro area that can issue unlimited amounts of global reserve currencies. The authorities in the UK and Switzerland –- who cannot rely on the ECB – can only pray that no accident happens to the giants they have in their own garden.

Leverage Ratio (total assets/equity 30-Jun-08 2007 UBS 46.9 63.9 ING Group 48.8 35.3 HSBC Holding 20.1 18.4 Barclays Bank 61.3 52.7 BBV Argentaria 20.1 18.6 Deutsche Bank 52.5 Fortis 33.3 26.4 KBC 24.4 20.5 Lloyd's TSB 34.1 31.0 RBS 18.8 21.8 Credit Agricole 40.5 34.8 BNP Paribas 36.1 31.5 Credit Suisse 33.4 31.5

Source: Authors' calculations on data drawn from FT.com