Europe has long been a place of economic stagnation. Aside from the odd place or two, such as Ireland or the Baltic States, Europe has generally seen its citizens’ standard of living languish over the years. Europeans are used to seeing inflation slowly eat away at their purchasing power, asset price inflation eat away at housing affordability and taxes reducing their disposable income. But when you are some of the richest people in the world, as measured by per capita GDP, stagnation isn’t the worst thing that can happen to you. What will to happen to the Europeans is less tenable: a repeat of the Japanese experience with their ‘Lost Decades’, but in a world with heightened international competition and the rapidly increasing productivity of developing nations. This version of the Lost Decades syndrome will be much more punishing.
On the surface, bank bailouts may seem like the appropriate thing to do when your banking system looks like a rocking Humpty Dumpty on the wall. The Japanese experience should have served as a warning to other governments against the dangers of bailing out banks. When Japan’s property and equity bubble burst at the end of the 90′s, the government hit the bailout peddle full steam in an effort to avoid bank runs. The result was the creation of “zombie banks”.
Banks in Japan had the real value of their assets crippled, forcing Japan’s central bank to come in and pump massive amounts of liquidity into the banking system to keep bank assets liquid. As banks used the extra liquidity to pay down their overstretched balance sheets’ liabilities, instead of lending them out into the real economy, growth stagnated for years. Japanese banks became simultaneously liquid and insolvent.
The usual process of bankruptcy is to have a judge look over the balance sheet of a corporation and determine how much of the liability side needs to be reduced to create a solvent and sustainably profitable firm. Equity investors are typically wiped out and debt investors get a ‘hair cut’ on their bonds, or see their bonds converted into equity (shares). The process reduces the debt of a bankrupt company to a level that can be covered sustainably. The alternative to this form of bankruptcy is a winding down of the business. If a company is recognized to have a permanently crippled business model and is expected to sustainably lose money, it becomes preferable to liquidate all assets and try and pay back as many debts as possible. In the US, these two forms of bankruptcy are called chapters 11 and 7 respectively.
Following a chapter 11 bankruptcy, two things may occur that will send a company back into bankruptcy or force it to liquidate. Either business conditions deteriorate and the company’s revenues no longer suffice to pay its interest costs, or the debt reduction is not steep enough from the get-go and the corporation’s normal revenues never really cover the newly diminished interest expense.
The emergence of zombie banks would occur when both the above mentioned difficulties arise. Bailouts, taking the usual form of a capital injection (the government buying lots of newly issued shares, to the detriment of previous share owners), has the partial effect of wiping out equity investors but saving debt investors. Without hair cuts to bonds a bank’s interest expense remains high, hence crippling the bank’s ability to inject loans to underpin the real economy. This problem is further compounded by a lack of chapter 7 style bankruptcies.
Banks’ profit margins tend to be extremely narrow at the best of times. According to the Bank of International Settlements, Spanish banks’ current profit margin as a percentage of assets is a measly 0.61% at present, while Germany’s big banks barely squeak out a 0.20% profit margin in 2011. Hundreds of variables will explain why European banks’ profit margins are razor sharp but Canadian and Australian banks rise above the 1% mark, most economists and financial analysts would chalk up a big part of this discrepancy to the competitive nature of banking in different countries. Canada and Australia are countries where industry concentration is highest, whereas in the US and Europe, the banking industry is atomized and fiercely competitive.
When chapter 7 style bankruptcies are effectively ruled out by bailouts, banking industries are prohibited from consolidating to a more natural level of concentration. Profitability is kept artificially low by excessive competition to issue loans and attract savings. The effect of too much competition in an environment where bank profitability is hampered by both excess industry atomization and crippled balance sheets is obviously the creation of these zombie banks. What European authorities are doing with the bailouts is stopping progress in its tracks. While bank bankruptcies might raise long term interest rates in the sector, it would mostly lead to consolidation and concentration which would embolden banks to lend to the real economy. This is how over-the-counter European bailouts are killing growth.
There is however bailouts of the under-the-counter sorts. The ECB has done what the Bank of Japan has tried before it, albeit in its own way. The ECB’s LTRO (Long Term Refinancing Operations) have been used to increase the liquidity of banks in Europe. Instead of its normal refinancing operation, which is lending to banks for less than 6 months with adequate collateral posted, the ECB has accepted lower quality collateral (despite what it may say) and refinanced maturities for up to three years at favorable rates. The idea was to buttress banks’ balance sheets to avoid a dry up in lending. However, the effect was lending cheaply to banks in PIIGS countries (but also elsewhere), who then plowed the money back into high yielding Spanish and Italian governments bonds and the like. So we are in a funny situation: bank profits in Europe are dismal (Italy’s banking sector is yielding -1.22% profits over assets), but their net interest margins are creeping up, all while real business is starved for credit.
Astute observers will have seen this all before in Japan. Most will be distressed at the puerile actions of leading bureaucrat financiers and economists. Many now regret the resignations of Jurgen Stark and Axel Weber, some of the last monetary hawks who warned against the current ECB roster of economists’ frivolous policies. Time alone will tell how foolish or not the current fiscal and monetary policies of the Eurozone are. Let’s all hope that a repeat of Japanese banking woes don’t make a repeat appearance and finally slay what was one of the noblest experiments of our times.
The views expressed in this opinion piece are the author's own and do not necessarily represent those of The Prince Arthur Herald.
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