The absence of structural reforms brings the effectiveness of ECB policy increasingly into question. The Financial Stability Board claims that banking reform is largely complete. Despite a quiet summer, there is plenty of evidence that it isn’t.
Policymakers are concerned about selective enforcement of budgetary rules, but the ECB seems undeterred despite rising sovereign debt levels and bank disapproval of their policies.
It has always been the stated position of ECB President Draghi that monetary policy alone cannot solve Europe’s financial problems; ‘structural reforms’ must be implemented by nations with the greatest imbalances. Slow progress on this latter front resulted in the adoption of the 2013 Fiscal Compact, under which every Eurozone government agreed to supervision of its national budgets by the European Commission.
However, no sooner were the Fiscal Compact rules adopted than “austerity” became a dirty word, and politicians became wary about calling for budgetary balancing. Against this backdrop, it is hardly surprising that the European Commission department responsible for policing national budgets has been taking a relaxed approach to its task. Spain and Portugal have been granted an extra year to get their deficits within previously agreed 2016 targets, and France enjoys repeated extensions of time.
Some high profile policymakers are worried. Jeroem Dijsselbloem, head of the Eurogroup (the 19 Finance ministers of the eurozone countries), said in June that budgetary supervision has come to be biased in favour of the larger countries at the expense of the smaller ones. This view was endorsed by Germany’s Finance Minister Schaeuble and central bank chief Weidmann, who called for the policing role to be transferred to a more independent limb of the Commission[[http://www.ft.com/cms/s/0/24575aee-320d-11e6-ad39-3fee5ffe5b5b.html#axzz4JNsgauJz]].
Is there political support for tighter enforcement of the rules? There have been two significant ballots this summer. Both the Brexit vote and the early September local German elections have been widely interpreted as consistent with popular electoral support for domestic policies such as immigration control, at the expense of further European integration. So we expect a continuation of light, if any, enforcement of the rules.
Why is this important? Although the concerned policymakers stopped short of explaining why the non-enforcement of budgetary targets matters, Daniel Gros, of the Centre for European Policy Studies, argued in a short piece “The Silent Death of Eurozone Governance” [[https://www.ceps.eu/publications/silent-death-eurozone-governance]] that the non-enforcement of these rules draws a line under hopes for further progress towards economic and monetary union.
“It is now clearer than ever that EU member states prioritise domestic political imperatives over common rules – and Europe’s common good.”
Assuming this trend continues, it seems likely that the pace at which sovereign indebtedness is increasing will accelerate, and there is plenty of evidence that this is happening. For example, in its latest monthly update, the Bank of Italy revealed that its liabilities, via the Target2 settlement system, to the central banks of other eurozone countries have increased in August by €35bn to a record level of €327bn. [[http://www.zerohedge.com/news/2016-09-07/italy-funding-panic-target2-liabilities-unexpectedly-soar-record-high]] This figure, which is not included in official figures for Italy’s public debt, has presumably jumped as foreigners have been selling Italian financial assets and Italian investors have bought foreign ones as confidence in Italian banks continues to ebb.
Such effects undermine the ECB’s continuing claims that its policies are “working”. But the ECB seems likely if anything to loosen policy further, hinting in August that the Brexit vote and the poor health of the Eurozone’s bank may require more action. But even beleaguered banks are turning against the ECB. Deutsche Bank recently attributed at least part of its difficulties to ECB policy. Writing in Germany’s newspaper Handesblatt[[https://global.handelsblatt.com/edition/499/ressort/finance/article/operation-successful-patient-critical]], CEO John Cryan spoke of the “fatal consequences ” effect of zero to negative interest rates on the elusive Eurozone recovery. Such policies were
“working against the goals of strengthening the economy and making the European banking system safer.”
The ECB might be forgiven for viewing this response, from such a prime beneficiary of its bank specific repurchase and funding operations, as biting the hand that has been feeding it.
Optimism from the Financial Stability Board. Despite the absence of eruptions, fears for the future grow.
Banking is perhaps the one area of activity in which the rules are set by a global entity – the low profile Financial Stability Board (FSB). At the end of August, the FSB issued a very upbeat report[[http://www.fsb.org/wp-content/uploads/Report-on-implementation-and-effects-of-reforms.pdf]] together with a 9 page cover letter[[http://www.fsb.org/wp-content/uploads/FSB-Chair’s-letter-to-G20-Leaders-in-advance-of-their-meeting-in-Hangzhou-on-4-5-September.pdf]] addressed to the G20 leaders timed to coincide with their arrival at the Hangzhou summit.
In the letter, FSB chair Mark Carney wrote that the report “highlights the achievements to date in strengthening the resilience of the global financial system”. On closer inspection, however, the evidence presented to support such bold optimism is grossly exaggerated.
Firstly, the FSB claim that the system has survived two recent “shocks”. The first refers to the market downturn in February, upon which we extensively reported. The second “shock” was the Brexit vote. We accept that the vote was unexpected, but since nothing of substance has yet happened and the only material and enduring market impact has been a weakening of sterling on the foreign exchange markets, it seems rather rich to describe this as a “shock” to the global financial system.
The Report is very light on substance. We maintain there has been very little recognition, let alone reform, of the areas of banking, such as derivatives, which were the silent store of so much systemic risk. For example, one of the unreformed, still troubling, features of derivatives is that the accounting treatment recognises up front years of hoped for income as ‘profit’. The counterparty’s obligations to make these payments will vary substantially with market movements, and this exposure is always uncollateralised at the point in time the derivative is written, if ever.
However, the FSB claims that such concerns have been substantially addressed by the new rules requiring clearance through central counterparties (CCPs). But CCPs do not address the perverse incentives that encourage the continuing aggregation of derivatives exposures, CCPs merely transfer the liability from the exposed party to a publically funded central counterparty. The FSB’s letter even acknowledges this when setting out its future workstreams, the quantification and measurement of these exposures:
“Since CCPs are themselves systemic, the FSB, [and other suprantional regulators] are working to strengthen CCP resilience, including improving their ability to recover after shocks (such as the failure of member banks)”.
The FSB’s report should reassure nobody. Moreover, it reads in stark contrast to the stream of bank specific bad news emanating from Europe in particular.
Italy’s systemic banking fragility, which we wrote about in July remains in the headlines, with yet another capital raising announcement from Monte dei Paschi di Siena. This bank has had two government bailouts since 2009 and two investor equity injections totalling €8bn in the past two years. Recent news is that its plans to offload €28bn of bad debts means it will be asking investors to subscribe another €5bn of equity.
There surely comes a point when the realisation dawns that some banks’ businesses are in such poor shape that the obvious cost of further recapitalisations seems unlikely to yield any discernible benefit. Why persist with more support for Monte Dei Paschi? It must be a matter of national pride combined with political embarrassment for the previous allocation of public funds. And of course, the government may prefer to avoid the remonstrations of losing bondholders by distributing these costs among the entire tax paying base.
The summer also saw the long awaited publication of Professor Dowd’s excoriating critique of stress tests. Admittedly focussed primarily on UK banks in 2015, many of the paper’s criticisms equally apply to the European tests. Dowd makes a compelling case that the stress-testing programme is nothinig more than a glorified PR exercise intended to present as sound and reformed what should be obvious to all as seriously overstretched banks.[[https://static1.squarespace.com/static/56eddde762cd9413e151ac92/t/579f53b66b8f5ba10895862b/1470059502224/No+Stress+II at p5]]
“Far from providing credible assurance that the banking system is safe, the stress tests are worse than useless because they provide false comfort, suggesting that the UK banking system is safe when it is in fact highly vulnerable.”
Notably, Professor Dowd demonstrated that every single UK bank would have failed the more rigorous stress tests of the Federal Reserve.
The Bank of England of course ignored this criticism and maintained the line that its stress tests show that the bulk of the work to recapitalise banking has been completed. But of course the Governor of the Bank of England is the same Mr Carney who heads the Financial Stability Board.