A euro fable

TH  was a fan of Bill and Ben the Flower Pot Men when he was a kid (link at end of post). And just as he was way back then he is lost for words over the Spanish banking situation.  It is all so predictable and has been for a long time.  He wonders what happens if you have a broke friend (Bill) who in turn has a broke friend (Ben), and you lend Bill money to lend to his mate. Does the loan solve the problem, or make it worse?  Perhaps Ben could get lucky by using the cash to short Bill’s bonds or, perhaps, the euro.  You never know.

Anyway, trying to just reflect on the “how we got here” story. So here is a story about the euro system. Torrens is sure that there is a moral at the end, but he’s not sure what it is. Once upon a time, there was a new Europe. It introduced a new currency, set to rival the US dollar. It combined the rich, mostly central and northern nations stretching from France, through Germany and Austria, with the poorer periphery countries from Ireland through Greece in the South with a common currency. The masters of the euro promised the latter vast riches as their living standards converged to those of the North. A common currency would increase trade and European integration. The poorer periphery would soon become like the richer core.
To aid this process, the new euro system was constructed in such a way to effectively cross-subsidise the borrowing costs for the Southern periphery by effectively giving their governments access to funding on the same terms as the northern counter-parts (essentially the euro system made it much more effective for European banks to buy cheap periphery debt to meet their regulatory requirements than to buy expensive northern debt). And borrow the periphery did; whether it was the government of Greece or the private sectors in Ireland and Spain.

Of course, the borrowing had to be financed from somewhere – mostly, but not entirely, from Germany via the banking system. The European banking system was a cobbled together set of national banking systems, which meant that it was difficult for banks in Spain, say, to borrow directly from German households or for German banks to lend directly to Spanish firms and households; the transactions generally involved two banks – one from each jurisdiction.

Anyway, so when the periphery borrowed it involved both periphery banks that originated the lending and German (and other core country banks) banks who raised the cash from German depositors. Some of the smaller German landesbank, which were inexperienced in international markets and willing to absorb the additional risks, were quite involved in this process. They were not overly worried about these risks, because the loans were being made against the higher levels of income (and hence capacity to repay) that these countries were expected to have when the debts came due.

The trouble was that the promised convergence in productivity levels was not occurring. While Irish banks were using their easy access to German savings to finance domestic investment and expansion, they were also lending to English home buyers. Spanish banks were using those savings to finance huge Spanish housing bubble.
Alas, when the US sub-prime crisis hit, which many European banks also had large exposures to, it became clear that the cross subsidisation had also led to a gross misallocation of capital in Europe. There were huge losses in the banking system that would have to be dealt with; but by whom? Would it be the periphery banks that originated the lending or the German banks that provided the financing?

Of course it is the periphery banks, which originated the lending, that bear the burden. They have the maturity mismatch – they lent long term to finance a construction boom, while German banks lent to these banks short term. The banks that were providing the financing simply chose not to roll over their loans, and Germany’s money went two places: into German bonds and to the ECB.

The latter happened because there was now also a mismatch between loans and deposits across jurisdictions – German banks with plenty of deposits and periphery banks with plenty of loans – in such a situation the ECB act as a clearing house must correct the imbalance if the system was not to completely breakdown. Through the target 2 system, the banks in the periphery received loans from the ECB (an ECB asset), while German banks received deposits at the ECB (an ECB liability). Suddenly the German banks had gone from bearing quite incredible risks to having some of the safest assets possible (German bunds and ECB deposits).

As a consequence of the set up of the system, all the risks from the periphery bank lending was crammed down on the periphery banks – there was no risk sharing. Instead there was an intensification of risks in the periphery and drastic removal of risks in the German core. The Irish banks were thus forced to seek a bailout or go bust. And now Spanish banks have been forced to do the same.

Banks are a national responsibility in Europe, and so the ultimate costs of the European banking crisis has become the burden of periphery tax payers. In a bizarre twist of fate, the euro system, which promised them so much, has now impoverished them. At the same time, because German savings have started to return home, the costs of borrowing in Germany have been driven to next to nothing and the those largely government owned banks in Germany that lent so freely (partly because of the government ownership that allowed them to take excessive risks) have ample funds while there periphery counterparts have been locked out by markets.

Oh and did TH ever mention that banks in other Euro system countries other than Spain and Ireland are also at risk?

And for the video junkies — a short video of Bill and Ben.

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