Friday, December 14, 2012

ECB dilemma

It was announced yesterday that  Europe will have a new, central bank supervisor run by the ECB, much as our Fed combines monetary policy and bank supervision. Be careful what you wish for, you just might get it.

One big unified central agency always sounds like a good idea until you think harder about it. This one faces an intractable dilemma.

Here's the problem. Why not just let Greece default?" is usually answered with "because then all the banks fail and Greece goes even further down the toilet." (And Spain, and Italy).

So, what should a European Bank Regulator do? Well, it should protect the banking system from sovereign default. It should declare that  sovereign debt is risky, require marking it to market, require large capital against it, and it should force banks to reduce sovereign exposure  to get rid of this obviously "systemic" "correlated risk" to their balance sheets. (They can just require banks to buy CDS, they don't have to require them to dump bonds on the market. This is just about not wanting to pay insurance premiums.) It should do for the obvious risky elephant in the room exactly what bank regulators failed to do for mortgage backed securities in 2006.

Moreover, it should encourage a truly European market. Greek, Spanish, Italian banks failing is no problem if large international banks can swoop in, pick up the assets, and open the doors the next day. Bankruptcy is recapitalization.  Greece needs a national banking system as much as Chicago (same population) does.

All well and good. And all diametrically opposed to the ECB's "crisis-fighting" agenda. The right arm of the ECB should be protecting the banking system in this way. But the left arm of the ECB is using banks as sponges for sovereign debt.

In trying to manage the sovereign debt crisis, the ECB has bought huge amounts of sovereign debt. It has lent  euros to banks that in turn have bought large amounts of sovereign debt (often, I gather, with not so subtle pressure from their governments).  It has lent more euros to the same banks to replace deposits that are quite wisely fleeing out of those banks.

How can the right arm protect the banking system from sovereign default, while the left arm wants to stuff the banking system with sovereign debt?

Converesely, how can the left arm do anything but print euros like mad, now that the right arm has responsibility for the banking system?  Lending to banks who buy sovereign debt was always excused by the idea that the bank shareholders bear the credit risk and national supervisors take care of that problem. Now it's in the ECB's lap. Politically, can the ECB really shut down national banks, stiff the creditors, and let them be taken over by big pan-european banks?

I bet on the outcome: print euros like mad, keep pretending sovereign debt is risk free, and prop up existing banks. Let's hope I'm too cynical. For once.


  1. Then, what do you think of the case of Bank of England which is exactly same as Fed or ECB?

    Professor, I think you are arguing that all central banks with supervision function have same dilemma and they should be divided into 2 institutions once Britain took before global financial crisis.

    In this world, I guess there are few central banks which is free from your "dilemma." The central banks of Japan, New Zealand, and Austria are the endangered animals which you think ideal. Right?

  2. "They can just require banks to buy CDS"

    Sure - they can buy CDSs from AIG and that will make the European system stable and robust just like it made the US stable and robust.

    There is no private institution with the capital to write meaningful amounts of CDSs on the sovereign debt of Italy or Spain.

    Part of the original problem is derivatives which were used by Greece to misrepresent their financial picture. Derivatives are not part of the solution. The world would be better off with a much smaller, not larger, derivatives market.

    1. This is silly. Writing CDS is a matter of how much, not at all. CDS are collateralized. If the army of bank regulators and tens of thousands of pages of Dodd Frank and comparable European regulation is worth anything it should be able to maintain capital requirements against CDS. Anyway, if you don't like CDS, then make them sell the bonds. They still have gas in the basement, and pretending it's a flower garden doesn't solve the problem.

    2. Professor Cochrane,
      I am really curious about who should sell the CDS to the banks. Maybe national governments can do it! AIG!
      The idea that this risk can be hedged out on a systemic basis is silly and deserves to be laughed out of the debate.

    3. Not sure what part of it you consider "silly". I was focused just on your comments regarding CDS. Requiring banks to hold CDS is not going to help if the entity writing the CDS becomes insolvent in a financial crisis and the burden just falls back on government through implicit government guarantees. There is no prospect that the full nominal amount of the CDS will be collateralized since the CDS market is much larger than the underlying real market.

      I happen to agree that the shareholders and bondholders of French and German banks should bear the consequences of bank purchases of sovereign and private debts from Greece, Spain and Italy.

      Dodd Frank could have been shorter if Congress had just had the courage to simply outlaw Credit Default Swaps and Interest Rate Swaps - then we would have had less to worry about in calculating capital requirements.

    4. Extrapolating AIGFP and the financial crisis to everything doesn't help in trying to specific things. There are of course lessons to be learned but making every problem into a problem it is not doesn't help one understand the actual issue at hand. Yes AIG went under because of CDS exposure and improper risk management at the holding company and at FP but that doesn't mean all CDS are bad and that they should go away. Honestly (not to state the obvious) CDS have had various positive affects on many firms, shareholders, bondholders and homeowners even considering the financial crisis and housing slump. And there are many different types of CDS each with its own issues for consideration. Interest rate swaps are the same. I mean, these aren't just used by AIG's, hedge funds and Goldman Sachs, they are used by Coca Cola, Kraft, airlines, and all sorts of other companies to help them manage their finances, reduce costs, and better facilitate their customers from soccer moms to other firms.

      I think it is right to presume under ideal conditions that such CDS could be written and exposure could be spread out among various parties (a small example being the various hedge funds we have been hearing buying up distressed Greek and Italian sovereign debt). I know Cliff Assness doesn't believe in uncertainty affecting prices which he wrote in some WSJ article a while ago, but I think in this case with large party to party contracts, uncertainty in terms of government support/intervention, a negative political stance on CDS and "vultures" and other factors are all contributing factors that we can label as "uncertainty" and that this "uncertainty" prevents a black and white approach to the problem.

      I agree that shareholders and bondholders of French and German banks should bear for the consequences of bank purchases and sovereign and private debts from Greece, Spain, and Italy, but I particularly don't believe German citizens and the other good paying citizens of the EU should.

  3. Being too cynical is like being too thin or too rich.

  4. Bank regulation is something I just do not understand, despite studying it in law school (maybe that's all you need to know about why I don't understand it).

    So Prof. Cochrane, I'm hoping you can help set me straight.

    My understanding is that "banks" need regulation for one, and only one, reason: they can experience runs. They experience runs because they have liquid liabilities (demand deposits) and illiquid assets (bank loans). That's how they make their money. My friends in finance tell me this is called a "carry trade" - when you borrow short and lend long.

    Obviously, this is risky. The problem is if your bank's in trouble, you're screwed (cue the obligatory scene from It's a Wonderful Life). So, we came up with a solution: deposit insurance. In return for a fee, banks could pass their own default risk onto the federal government. This was good because it stopped bank runs. It was bad because it created moral hazard. When banks approach insolvency, deposit insurance causes them to take bigger and bigger risks, because they get the upside and the gov't bears the losses. We tried to solve the moral hazard problem with bank regulation (capital requirements, risk regulations, etc.) It doesn't always work (S&L crisis). But, with federal deposit insurance, good old-fashioned bank runs were more or less a thing of the past.

    Here's the problem that manifested itself in the last crisis: everyone turned into a bank. A bunch of institutions (including money market mutual funds!) had assets that they thought were completely liquid, from MBS to auction-rate securities, to commercial paper. When things went bad, those assets, overnight, and to the shock of pretty much everyone, became ILLIQUID. Big financial institutions still had liquid liabilities (repo agreements, basically demand deposits), which meant BOOM, anyone could experience a bank run. And many institutions did.

    So it's easy to criticize Dodd-Frank, but what's the alternative? "Deposit" insurance for everyone? What's a deposit? You want *regulators* to fix the risk profiles of the whole industry?! Regulators are much, much worse than the market about running a sophisticated risk management system. Regulators had ZERO CLUE what was coming as late as the summer of 2008. A lot of financial institutions had zero clue. What makes you think we'll do better in the future?

    Right now you want the regulators to focus on sovereign debt. Who knows if that's the next financial crisis or not? No one knows! What yield-producing asset should banks hold instead? One day you're holding a "safe," "liquid" asset, and the next day it's toxic waste!

    So help me out here: deposit insurance for everyone? Or let the free market decide? Those seem to be the only two alternatives for me. Everything is just noise.

    1. I cannot answer for the Prof, but I say that if and institution is going to make large commercial and real estate loans, then yes they should also be forced to purchase deposit insurance and agree to basic regulations such as capital requirements. However I also believe that the regulations themselves have become too byzantine and onerous. All that is needed are very basic rules demanding, for instance that riskier loans should have bigger down payments, or a larger collateral ratio, and that the government refrain from setting up abominations like Freddy Mac and Fannie May which absorb risk from the private sector and pass it on to the taxpayer.

  5. The Eurozone's approach up to this point is to but larger and larger guarantees behind bad loans. The ECB backs the Government of Spain which backs the Spanish banks who have made a bunch of bad loans. This means that the bad debts are never resolved, and this creates a long term drag on growth. Futhermore it actually increases the systemic risks.

    The EZ needs healthy banks that resolve bad debts in an orderly fashion. Don't fear default! The ECB should be working or rules such that defaults can happen without systemic risks ripping everything apart. Too big to fail is too big to exist.

  6. But what point can you score when you besiege a home of an opposition leader? What is the real worth of your regime when a whole police institution sends out a tweet denying the attack on the home of your opponent by saying he was scared of police of foot patrol? sms lån


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