Monday, 11 June 2012

Spanish bank bailout – another half-baked solution

Even thought today’s €100bn Spanish bank bailout was hailed by Europe’s policymakers and markets as it once again temporary saved Spain and consequentially Europe from much bigger turmoil, the crucial emphasis is on the word temporary. In this case, as in any, temporary easing cannot be a good thing. Similar to the Long Term Refinancing Operation (LTRO) done by the ECB in December that was supposed to provide European governments with much more time to engage into and finally start with necessary institutional and restructuring reforms, the bailout effect is bound to only last for a few months, or maybe not even that much. Even more importantly (i) it won’t do any good for Spanish consumers or businesses, (ii) it will provide only limited time for the government to carry on with reforms, thereby not helping them much, as sooner or later the situation is likely to be the same, and finally (iii) it won’t even encourage Spanish banks to lend more. 

I’ve already covered the ECBs policies with respect to the temporary effects of the LTRO, and the conclusion was that the effect was surprisingly temporary – it wasn’t long term at all. It offered relief only for a few months, and mostly to the governments who didn’t do anything to seize this moment. It didn’t do much to increase consumer and business confidence, but this is expected since its final effects weren’t aimed at helping businesses or consumers at all. It was supposed to help banks. So, we ask ourselves, how is it possible that the Spanish banks need even more funds to keep them from defaulting? Could it be that the ECB’s first LTRO only made things worse by offering false hope to the Spanish banks and governments, thereby only strengthening the argument Germany is constantly holding against Europe – that massive bailouts will only cause more moral hazard, more profligacy and an lesser commitment to reforms? 

Then why did this bank bailout even go through? 

Well, Spain needed something to restore credibility in its banking system. It needed desperately to avoid a banking collapse. The banks really did need more money. If it weren’t for the ESM funds, this would imply that the government itself would have to bailout the banks, which would be an impossible task endangering its solvency and pushing the entire country into default. This would be a much more expensive thing to finance at the moment. Some even say impossible. 

So is Spain now out of danger? Not at all. With expectations of negative growth and rising unemployment the deficit will be even larger than projected, meaning that more borrowing could be on the way. Let’s not forget, Spain still needs €36bn this year to cover the deficit and keep the country going. 

And who would buy the Spanish debt? Only the Spanish banks, as investors are fleeing from Spanish bonds. The big banks are also staying away from government bonds, afraid of being pulled in the turmoil. So the only banks buying government debt are the same ones that are being bailed out (!). That makes the current bank bailout in fact a government bailout – or a “credit line” to the government, to be more precise. (Technically the story is more complicated than that - even more so as the government will have to repay the European loans made to the banks, but the idea is essentially the same).

The whole conundrum makes the entire thing look even more absurd and even more of a futile attempt to postpone the inevitable - another collapse of Europe's banking system.


As for the ECBs role in the entire picture, let’s look at how it’s LTRO resulted in the end? Below is the graph depicting yields on 10-year government bonds from Spain, Italy, Portugal and Greece. 

Source: Bloomberg
Not very effective was it? Remember, it was done in December 2011. The graph for Spain alone offers an even better insight (bear in mind that Spanish banks received almost half of all LTRO funds):

Source: Bloomberg
All it did was provide a temporary relief for governments and banks that didn’t even last as long as investors and particularly policymakers were hoping. This isn’t surprising as none of these actions helped the real sector of the economy. Banks received funds which they used to buy government bonds (again an example of an indirect “credit line” to governments). They didn’t increase their loans to businesses or to the public. 

Extra money created and spurred into the system at this point would provide the same result – no boost for the real sector, only a temporary effect on investor optimism and a one-off exchange of money between banks and governments for newly issued government debt. The rest of the money would be used by the banks either to satisfy the capital standards (hold more reserves) or would be deposited at the central bank at a close to zero nominal interest rate. 

The solution therefore doesn’t come from aggressive monetary policy, not at this drastic stage of severe lack of investor confidence and sentiment among the bankers. The answer isn’t fiscal policy either but a pledge to reform; the labour market, the public sector, to release money in the system by cutting regulation and removing barriers for businesses to export and expand, and most importantly to maintain political stability in order to attract foreign investments and keep the country going (even though attracting foreign investments into Europe would require a Gargantuan effort at the moment).

Monetary policy is useless not so much because of the zero lower bound, but due to the confidence among banks and what they plan to do with the money they receive. One doesn't increase bank lending by giving them more money on one hand and asking them to hold more capital on the other. The signals sent to them are heavily distorted and are completely disregarding the real sector of the economy. Both bank confidence and real sector confidence are best restored with a proper institutional reform

6 comments:

  1. But how can this be? I still remember my first Econ professor telling me that Government debt didn't count, after all we owe it to ourselves!

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    1. ...it wasn't just government debt, it was the whole debt including households, private sector, banks and government...
      ...a bailout is malign since it only increases total debt instead of decreasing it...they should all just default and start over..like Iceland..

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    2. I agree, it wasn't just government debt. Total household and corporate debt levels were also very high (I covered that in a post back in March).
      As for Iceland - that's a good example, I've been planing to write a text on them for some time now..

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  2. That's what happens when you throw money at things that are insolvent. They keep coming back for more, and more, and more.

    Vuc, you talk about reforming the public sector, cutting regulation, etc. - and all this is fine and necessary. But you don't mention the dreadful state of European banks - their appallingly risky balance sheets, their fudged asset valuations, their shortage of capital. Economic reforms will fail unless they include reform of the banking sector. Zombie banks need to be allowed to fail. Europe needs an FDIC, not more bailout money.

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    Replies
    1. Yes, you draw an excellent point. The banking sector reform is essential as well. But I can only see one coming from constituting a banking union in which a type of FDIC can be created. In addition to letting the zombie banks go under, absolutely.

      The plea to reform always has to include a broad reform and a broad solution. It will be hard, but it is, in fact necessary.

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