IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
Bumpy springtime for the ECB: no recovery, another major blunder and more regulation. Times ahead are becoming increasingly hard as more EU countries are in trouble, new regulations are being introduced and banking and sovereign borrowing are difficult.
There were only two items of good Eurozone news last month. Ireland, the bailout ‘poster child’, accessed the 10-year bond market for new debt at a cost of 4.15% pa, lower than the cost of Italy or Spain. Germany continues to post positive GDP growth rates, but barely so (around 0.6% in 2012).
On the other hand, there were several pieces of bad news. None of the other bailout patients is recovering. Both Greece and Portugal are struggling with their bailout terms, Portugal’s GDP having declined 7% since its 2011 rescue compared with the 4% figure projected at the time.
Poor news also emanated from France, where President Hollande had warned early in the month that the 2013 deficit would be 3.7%, well above the expected 3% mark. In a similar vein, Spain’s central bank now believes that its 2013 public deficit will reach 6.7%, compared with the 4.5% ratio promised to the EU last year. Moreover, shareholders in its nationalized banks learned grim news. For example, in Bankia (recipient of a €19 bn government bailout), shareholders have been informed that they are bound to lose some 99% of their investment, while junior bondholders and preferred stockholders at this and the other 4 nationalized banks had writedowns imposed of 30 – 60%.
Another rescue melodrama played out in March. After 9 months of gestation, the terms of the €10bn loan to Cyprus were agreed, then rejected, then quickly restructured in another all night Brussels session. The final terms guaranteed (sub €100k) bank depositors, but wiped shareholders, bondholders and severely damaged larger depositors. At this moment, it appears that the victims of the bail-in operation will lose some 6 bn euro. Yet, the precise amount is unknown and the same comment applies to how the losses are going to be shared by the various actors.
All in all, the Cypriot episode seems to go in the right direction: bad investors/depositors pay the cost of their reckless or thoughtless decision to give their money to agents that kept buying Greek bonds. True, the EU authorities had been reassuring investors that Greece was safe for year, starting in 2010, when the ECB handed out over 100 bn euro to Athens. Nonetheless, the lesson is clear: trust the market, rather than Frankfurt or Brussels.
At the same time, however, two points have emerged rather forcefully. First, it has been clear that the EU is hardly in control. In particular, it has mismanaged the Cypriot crisis by sending out contradictory messages for well over three weeks. In the end, Eurogroup finance chief Djisselboem stated that depositor bail-in was the new norm, but a few hours later he was forced to retract the statement, presumably for fear of triggering more widespread deposit flight. One wonders what the real EU rule is going to be: bail-out, bail-in, or both? Second, the ‘temporary’ introduction of controls on capital movements sets a bad precedent, and will surely be considered as a concomitant to any future depositor ‘bail-in’ solution to major banking collapses. Clearly, the exchange controls now in place for Cyprus must be lifted quickly for the policy to have any chance of being perceived to be viable. If they remain in place for the medium or long term, their imposition will come to be viewed as the start of the end of the single currency: some euros will be perceived as exportable, and some others as de facto inconvertible.
The European Markets Infrastructure Regulations, which recently came into force, are presented as the cornerstone of post-crisis regulatory reform. On March 15th, the first wave of reporting and compliance rules became effective.
The regulations are broadly on three levels:
> All derivatives, both listed and Over the Counter (OTC) must be reported;
> If the European Securities and Market Authority (ESMA) deems any OTC derivative eligible for “central clearance”, then they must be so cleared (Central clearance means that each bank’s counterparty will be a government backed “exchange”, rather than another bank.This supposedly immunises banks from the risk of default of each other);
> Margin and collateral posting rules (they refer to situations in which risk positions change and the underwater party is required to deliver assets to demonstrate that the it is good for its losses).
The thinking behind these regulations is that the 2008 collapse was triggered by counterparty failure. Therefore, it is believed that the greater the use of clearing houses, the lower the risk of future failure.
Tons of ink have been devoted to discussing the nature of derivatives and of the risk involved. We shall spare the reader further comments. Yet, it might be useful to underscore that the assumption that central clearance and margin directives will allay a future crisis is false. Margin and collateral requirements have always been at the core of derivative trade negotiations between banks. The risks posed to financial stability by derivatives stem from inaccurate accounting – the ability to book profits by backing out a trade when accurate accounting would record a doubling of the risk. Centralisation does not address this.
Many commentators hope and pray that the liquidity provided to the banking system via ECB repo rules, QE and ultra low interest rates is fuelling lending to national economies. Unfortunately, such commentators continue to misunderstand the way banking works, in particular the effect of the misaligned incentives for bankers.
Since the outbreak of the crisis, the main problem for most bankers has been the absence of easy profits. In 2010 and 2011, the typical carry trade was to repo poor grade (but qualifying assets for ECB funding), then redeposit the funds with the ECB. By mid 2012, the ECB had worked this out and set the deposit interest rate to zero. Banks were forced to use the cheap funds to buy assets. What kind of assets did they choose?
Last year, the focus was on investment grade assets such as mortgage backed securities. The highest quality UK RMBS (AAA rated) were being issued at spreads of 150-160bp. Before long, however, cheap liquidity drove these spreads down to today’s 50 bp. Attention next focussed on high yield opportunities such as bank subordinated debt, but recent losses imposed on such bonds have dampened enthusiasm. For these reasons the re-entry of Portugal and Ireland to the capital markets has been very good news for bankers. Bonds issued by these countries can be purchased by banks and pledged to the ECB in return for financing at an interest rate of 0.75% pa. True, haircuts apply depending on rating. For example, in the case of Portugal, this would generate a carry profit of 4.15% pa on 90% of the funding, the bank would have to self-fund the other 10%. Nonetheless this remains a particularly attractive trade for big banks, who could deem the asset a ‘hold to maturity’ bond to avoid the risk of booking mark-to-market losses, should there be another wobble as to Portugal’s ability to service its restructured debt.
The bottom line is straightforward. Carry trade activity remains the pre-eminent activity of banks owing to accounting and regulatory capital regulations. Little if any of the cheap funding will be deployed away from financial assets and into the ‘real economies’. Bubbles are simply being re-inflated.