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Willem H. Buiter CBE, FBA
Professor of European Political Economy
London School of Economics and Political Science
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The financial crisis of the north-Atlantic
region that started in 2007 is, by most
metrics, the biggest financial crisis ever
The global contraction of real economic
activity that followed it will undoubtedly be
the deepest and longest downturn since the
Great Depression
If policy makers screw up, it could still
become worse than the Great Depression
I don’t consider that likely
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Today’s advance industrial country financial crisis are
rather like the EM crises of the 1970s, 1980s and
1990s.
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Dysfunctional banking and financial systems
Frozen impaired financial markets
Lack of fiscal spare capacity
Convergence of public sector & banking sector credit
ratings (in a crisis, all debt is public)
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risk of ‘sudden stop’
▪ Double crisis : banks and sovereign debt
▪ Triple crisis: banks, sovereign debt & currency
 Main difference from EMs: global reserve currency status
of US & Eurozone
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Pay special attention to the inconsistent
quartet
 Small country
 Large internationally exposed banking sector
 Own non-global reserve currency
 Limited fiscal spare capacity
▪ Iceland, Switzerland, Sweden, UK, Ireland (3 out of 4)
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After the banking crisis and the (private
sector) financial crisis are we entering a
period of sovereign debt crises and currency
crises?
If so, will it be restricted to EMs and small
countries (especially in CEE), or will it involve
larger countries, including the UK & the US?
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Financial excesses (credit booms, asset bubbles) as bad in
Eurozone as in US and UK
 Positive exceptions:
▪ Spain’s dynamic provisioning
▪ Italy’s stay-at-home conservatism (except for UniCredit & Intesa Sanpaolo )
 Negative exceptions:
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Spain’s wild construction boom/bubble
Ireland’s wild construction boom/bubble
Ireland’s banking bubble
Germany’s Landesbanken
Lending to CEE & Balkans
Lack of transparency of Euro Area banks; failure to recognise losses & start
recapitalisation
▪ Euro Area behind US, UK and Switzerland in recognising bank losses and
addressing recapitalisation
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Real economy downturn at least as deep in
Euro Area as in US & UK.
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Positive:
 Euro Area: Common Currency, LLR, MMLR
 European Commission (Competition Directorate)
attempts to preserve competition in banking
despite egregious state aid & new banking
Darwinism (survival of the fattest and the
politically best-connected)
 Less protectionism among EU members towards
each other
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Negative
 No common policy on deposit insurance
 No common policy on unsecured creditors of banks
 No common special resolution regime (SRR) with
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structured early intervention (SEI) & prompt
corrective action (PCA)
No common policy towards recapitalising banks
No common policy towards guaranteeing assets or
liabilities, new lending or new borrowing
No common fiscal stabilisation measures, modulated
according to ‘fiscal spare capacity’
Strong protectionism in financial and ‘posted workers’
areas.
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... even if it is sound – something most crossborder
north-Atlantic banks are not, but for past, present
and anticipated future government financial support
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Banks need: the Holy Trinity of financial stability
Liquidity support (central bank as lender of last resort &
market maker of last resort)
2. Solvency support (Treasury as recapitaliser of last resort)
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Because of 1. and 2.
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3.
Banks get regulation & supervision
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Reasons banks become too big, too interconnected, too
complex and too international to fail:
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Economies of scale
Economies of scope
Monopoly power (scale in a given activity)
Conflict-of-interest synergies (bundling many activities)
Lobbying power/political clout
Tax arbitrage
Regulatory arbitrage
Desire to become too big, too interconnected, too complex
& too international to fail
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Too big to fail means too big to be private
 Public ownership of very large institutions
 Smaller private banks and other financial institutions
▪ capital ratio requirements increasing in size of bank
▪ More aggressive anti-trust & competition policy (European Commission)
▪ Separate investment banking from commercial banking
▪ Prevent conflicts of interests within investment banks and commercial banks by
‘unbundling’ further (Glass-Steagall on steroids)
▪ No public (listed) companies in investment banking
 No economic efficiency problems:
▪ economies of scale in banking exhausted before $100 bn balance sheet.
▪ Economies of scope non-existent (span of control and lack of focus problems).
In the short term, fewer and larger banks
In the medium term, more and smaller banks
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Classic example of market discipline undermined
by political economy considerations
Too big to fail is a financial stability myth, but a
powerful political economy reality
Orderly resolutions of
bankruptcy/defaults/insolvencies of even the
largest banks and financial institutions are easy
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Requires
 Special Resolution Regime with Structured Early
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Intervention and Prompt Corrective Action – pre-empting
Chapter 11 & Chapter 7: regulatory insolvency joins
balance-sheet insolvency and liquidity insolvency .
Ability to ring-fence payment, settlement, clearing,
custodial activities of banks (& possibly counterparties of
banks also).
(Possibly) counterparties (CDS holders) senior to
unsecured creditors
Clarity on the exact seniority ordering of all claimants
Political strength to resist pressure from unsecured
creditors (pension funds, insurance companies, other
banks) and other lobbyists
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Good Bank -Bad Bank
Deconstruction of RBS Group end-2008 Balance Sheet
(following the
Bulow-Klemperer-Hall-Woodward approach) (£ bn)
RBS
Good Bank
Bad Bank
Assets
Clean assets (good & bad)
1,012
1,012
-
325
993
325
993
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-
-
460
2,330
2,330
460
899
899
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452
-
452
Derivatives
Total liabilities
Equity
971
2,322
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971
1870
460
452
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Total liabilities & equity
2,330
2330
460
0.34%
20%
1.7%
Toxic assets
Derivatives
Equity in other bank
Total assets
Liabilities
Deposits
Debt securities & other
non-deposit liabilities
Capital ratio
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Central banks, Treasuries and regulators/supervisors
are national
Repatriation of cross-border banking
 No more cross-border branches regulated &
supervised by home country (Icesave)
▪ EU principle of mutual recognition, single passport RIP
 Only independently capitalised subsidiaries, with own
assets & liquidity; managed at arm’s length from
parent & regulated & supervised by host country
 Home country Treasury cannot be expected to bail out
foreign subsidiaries of national banks
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Special problems of the EMU
1. One central bank for 16 countries
2. No fiscal Europe
3. No European regulator-supervisor for border-
crossing systemically important financial
institutions.
4. Because of 2., credit easing by ECB/Eurosystem
problematic: who recapitalises the ECB?
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Central bank’s conventional equity, W, need not
be positive, but its comprehensive net worth,
V = W + S – E –T , must be positive, lest it either
is at risk of failing to meet its financial
obligations, or will have to raise S and thus
future inflation to restore solvency.
Restoring solvency even through seigniorage
may be impossible if the exposure of the central
bank is to foreign currency assets or index-linked
assets.
In that case only a low or negative realisation of
T can restore central bank solvency
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ECB itself small and irrelevant
Eurosystem (ECB + 16 Euro Area NCBs) large
and relevant, but not fully integrated
NCBs share losses incurred as a result of
Eurosystem monetary operations, liquidity
operations and credit-enhancing operations
NCBs do not share losses incurred by NCB
acting as quasi-fiscal agent for national
Treasury
NCBs do no pool capital.
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Eurosystem Assets, 08/-5/2009
Assets (EUR millions)
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Gold and gold receivables
Claims on non-euro area residents denominated in foreign currency
Claims on euro area residents denominated in foreign currency
Claims on non-euro area residents denominated in euro
Lending to euro area credit institutions related to monetary policy
operations denominated in euro
Other claims on euro area credit institutions denominated in euro
Securities of euro area residents denominated in euro
General government debt denominated in euro
Other assets
240,817
159,299
123,101
21,359
Total assets
1,795,099
653,352
26,453
292,405
36,790
241,523
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Eurosystem Liabilities, 08-05-2009
Liabilities (EUR millions)
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Banknotes in circulation
759,502
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Liabilities to euro area credit institutions related to monetary policy
operations denominated in euro
264,137
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Other liabilities to euro area credit institutions denominated in euro
436
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Debt certificates issued
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Liabilities to other euro area residents denominated in euro
139,090
5.1
130,717
0
of which General government
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Liabilities to non-euro area residents denominated in euro
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Liabilities to euro area residents denominated in foreign currency
1,548
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Liabilities to non-euro area residents denominated in foreign currency
11,407
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Counterpart of special drawing rights allocated by the IMF
5,551
Other liabilities
11 Revaluation accounts
12 Capital and reserves
Total liabilities
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177,993
159,644
202,952
72,840
1,795,099
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Consolidated financial statement of the
Eurosystem as at 8 May 2009:
 Bad news: Eurosystem has only €74 bn of
capital and reserves & €1,795 bn worth of
assets, i.e. 24.6 times leverage
 Good news: Eurosystem’s balance sheet is 20%
of Euro Area annual GDP & monetary base (€1
trillion, 75% currency) is about 11% of GDP (€9.2
trillion)
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With 4 % trend nominal GDP growth a reasonable
seigniorage benchmark is 0.33% of GDP each year
(currently €32bn)( required reserves are
remunerated).
 If long-term safe interest rate exceeds long-term
growth rate of GDP by one percent, capitalised
value of seigniorage is 33% of GDP, more than 1.5
times the balance sheet of the Eurosystem.
 Safe but beware:
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 growth of balance sheet of Eurosystem
 Financial development and crime-fighting could reduce
seigniorage revenue
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 Is the ECB too independent to play a
Euro-Area- or EU-wide role as
regards macro-prudential
supervision & regulation?
 ECB may have to chose:
independence and irrelevance or
less independence and greater
relevance.
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