May 30, 2011
Is the European Central Bank (ECB) Europe’s AIG?
In other words, will the ECB be left holding the can, having lent all this money to the peripheral countries in order to save rich banks in Germany and France, in the same way as insurance giant AIG was destroyed by the sub-prime market?
If you remember back to the Lehman crisis, it was the collapse of AIG that really spooked the world’s financial markets. It had recklessly insured most of the toxic waste of Lehman’s and other banks’ balance sheets – all the sub-prime mortgages and worse.
When they all defaulted, the damage went straight on to AIG’s balance sheet as the insurer of last resort.
The ECB in 2011 is beginning to look Like AIG in 2008. It is certainly also beginning to sound not like an institution that is in control, but an institution that is beginning to panic.
For example, speaking on Thursday, executive board member of the ECB, Lorenzo Bini Smaghi (who, despite sounding like a character from Lord of the Rings is actually an Italian economist) opined that high-debt countries must stick to the terms of their bailouts. If they don’t, they risk having their banks cut off from ECB capital measures. Surely this is not how central banks work?
There are two things worth noting about this statement. First, why does an executive board member of the ECB think it is part of his job to place political pressure on democratically elected governments in Europe? He is a civil servant, nothing more.
He should leave the political manoeuvres to people with an electoral mandate.
Second, why is the ECB worried about whether the Greeks default or not? Currently two-year Greek bonds are yielding 25 per cent. There is a good reason for that – everyone knows that Greece is about to default.
Of course, if everyone knows this, then so does the ECB. And if the ECB knows this, it has to be placing very large haircuts on the value of Greek bonds when it accepts them as collateral for liquidity operations. It makes sense that when Greece is on the verge of default, the central bank which is taking Greek assets as collateral should be only giving the Greeks a fraction of the face value of these asset because the risk of holding them and giving real money in return is enormous.
Interestingly the ECB is not applying these haircuts. It emerged in an article in German magazine Der Spiegel this week that the ECB is not placing correct haircuts on the bonds. It is not looking at this collateral and saying, ‘‘This is risky stuff and we are not giving you good money for bad collateral’’. It is making the same mistake that the financial market- and AIG in particular – was making before 2008.The ECB is mispricing risk and it is beginning to panic.
In 2008, many banks in Europe were caught holding assets that had little or no value.
For example, an Irish bank had lent out â‚¬3 million for a field in Athlone which was falling in value towards â‚¬100,000. Because of the so-called ‘systemic value’ of financial institutions – meaning that one bank might bring down other banks, and risk damaging the euro, the ECB decided that no bank in Europe should be allowed to fail.
So, instead of letting banks collapse and risking a run on the euro, the ECB stepped into the market. It did what the Leaving Cert economics tells you a central bank should do during a financial crisis: it acted as lender of last resort to the troubled institutions.
This worked for some banks as it gave Them a chance to trade out of their difficulties. With extra government capital injected in the crisis in the form of equity, many European banks are today in a position where they no longer have to rely on the ECB to get liquidity.
They are credible enough to go to the market and raise the money they need from private sources – namely other banks or other investors.
But, as this column argued as far back as 2002, the flaw in the eurozone was that countries like Ireland and Greece would get too much credit in the boom and too little in the bust, rendering them bankrupt in the downturn. Because of this, our banks are still unable to access funding from the market. No one bar the ECB will touch us.
The ECB now finds itself holding nearly â‚¬300 billion of ‘assets’ from Greece, Ireland and Portugal. But the assets are not worth â‚¬300 billion. It has some buffers in place from the haircuts or discounts it has imposed on those assets. But if the haircuts are less than 100 per cent, they are not big enough for a major default event, as is now likely in Greece.
So what is the ECB to do? It now finds itself holding the can for the mistakes made by the commercial banks upto 2008, and by itself since 2008.
This would be extremely worrying if it were a bank, but of course it is not a bank in the normally understood meaning of the word. It is a central bank and this means there is one important difference. The ECB does not have to ‘earn’ money to have money – it can simply print it.
So, let’s play out a scenario. The Greeks default. This means that the ECB has to take a loss on its ‘balance sheet’ of â‚¬50 billion. For a normal bank, this would mean the bank would be bust. But the ECB’s balance sheet is a strange beast. The ECB makes its balance sheet balance, not the other way round.
By this, I mean the ECB looks at its liabilities and creates assets to match. It really is that simple. So if the ECB finds itself taking a â‚¬50 billion loss, it can go to its member central banks and ask them to get the money from their governments. Or it can write â‚¬50 billion into the assets side of its balance sheet and bother nobody about the loss.
This is what Ben Bernanke, chairman of the Federal Reserve, has done in the US – and the world hasn’t ended there. It is what the ECB should do here, and you can bet that the world won’t end here either.
But the really worrying thing is that you have central bankers who don’t seem to understand central banking – now that is a problem.
When you print the cash, you are the boss, you can do whatever you like to solve a crisis.
For example, our central bank in the 1980s continued to accept government debt for cash, even when the government was issuing debt as if it was going out of fashion. The ECB can do the same thing.
The issue is not about rules and regulations any more, it is about a mindset shift. The ECB top brass has to understand that the world has changed.
They have to see the world not as they would like it to be, but as it is. Then once they have done this they need to stop panicking and appreciate that the solution is in their hands.
The ECB should stop shouting stupidly at politicians and begin to behave like the true, credible institution it so desperately craves to be.
PS: I am travelling today to Argentina for business, but I will keep you posted on the website and here on what a country that has defaulted looks and feels like.