Too Much Control

New ECB Powers Will Create Zombie Banks

Martin Helwig_Bert Bostelmann
  • Why it matters

    Why it matters

    Mr. Hellwig is a well-known critic of the ECB’s approach to helping ailing banks.

  • Facts

    Facts

    • Mr. Hellwig believes the ECB should not be lending to insolvent banks, known as zombie banks.
    • The new ECB stress tests for banks will be unable to credibly evaluate them because to do so regulators would have to look at each individual loan and that is too time consuming.
    • He agrees the way the ECB was assigned banking supervision authority was incorrect and backs legal moves challenging that.
  • Audio

    Audio

  • Pdf

On a summer day on a hotel terrace in the former German capital of Bonn, Mr. Hellwig spent two hours discussing disincentives that have been created in the European financial system. He accused the European Central Bank of bending to politicians’ will and being too easy on banks in its ongoing “stress test” examination of their balance sheets, creating “zombie banks” in the process. He is skeptical of the ECB’s latest efforts to revive lending to the euro zone economy, and fears the ECB will be open to a conflict of interest as it adds responsibility for supervising banks to its existing role as the guardian of monetary policy.

Handelsblatt: Mr. Hellwig, Mario Draghi, the president of the European Central Bank, has announced new offensives in the fight against the credit crunch and deflation. One of his proposals is a large-scale purchase of asset-backed securities. How do you feel about the idea?

Mr. Hellwig: I’m not familiar with the details, but I’m skeptical. The ECB wants to relieve pressure on the banks’ balance sheets so that they can issue more loans. This kind of balance-sheet relief has existed before, in the years leading up to the crisis. Mortgages were securitized and the resulting asset-backed securities were sold worldwide. The mortgage banks had no reason to pay attention to the quality of borrowers, and as a result, billions in subprime mortgages were issued, securitized and brought into circulation. The loans were taken off the mortgage banks’ balance sheets, and the result was a crisis in the financial system.

Now the ECB apparently intends to purchase only highly rated securities, and the banks are to be liable at least for initial losses associated with the securities.

But that leaves the bulk of the risk with the bank, and the bank isn’t truly receiving any relief. Actually relieving the banks of risks reduces their liability and adversely affects the quality of lending. It’s an unavoidable dilemma. The proposal that countries guarantee the risks isn’t helpful, either. It would relieve the ECB of its burden, and yet taxpayers would end up being liable for the banks’ faulty decisions.

Was it the right decision to make the ECB the supreme supervisor of Europe’s largest banks?

Transferring bank supervision to the ECB means more power and responsibility for this institution, but without any real discussion of the pros and cons of this approach. When the decision was made in June 2012 to Europeanize bank supervision, the only objective was to make it happen as quickly as possible. This is why the Europeans sought to avoid amending the EU Treaty and used Article 127 of the existing treaty instead…

…which permits the European Council to assign, by decree, “special duties in the realm of bank supervision” to the ECB…

This approach made it possible to avoid any discussion of the issue of whether the ECB or a separate agency was to be charged with European bank supervision.

A complaint has now been filed against this approach in Germany’s Federal Constitutional Court. How do you feel about that?

I agree with the plaintiffs that the assignment of total responsibility for bank supervision is not covered by the treaty. In my view, “special duties” are not the same thing as general responsibility. In principle, I think the Europeanization of supervision is necessary, but I fear that it destroys the public’s faith in democracy when these kinds of decisions are made on weak legal grounds.

Aside from legal issues, we’d like to know whether it makes fundamental sense to combine monetary policy and bank supervision within the ECB. Something that seems necessary in terms of monetary policy can harm financial stability.

Indeed. Conflicts over objectives are especially likely when both the economy and the banks are ailing. In that case, monetary policy may focus on maintaining a high level of lending to businesses and private households, while precisely the opposite is needed for financial stability.

So you favor a separation of monetary policy and bank supervision?

Yes, in principle. However, the central bank always has to be kept informed of how banks are doing. Banks are an important part of the monetary system. The central bank has to know how banks, which contribute to the application of monetary policy measures to the real economy, are doing.

But receiving information doesn’t mean performing a regulatory role…

That’s true. Incidentally, monetary policy can also be corrupted by supervision. If regulators sanction developments that lead banks into crisis, the central bank will be tempted to provide the banks with low-interest loans to help them get back on their feet. The temptation is even greater when this enables the central bank to cover up mistakes in its supervisory duties.

Zombie Banks-01

Starting on Thursday, the ECB will offer banks new long-term loans, under the condition that they use this money for lending purposes. Doesn’t this threaten financial stability?

This is indeed a problem. In taking this approach, the ECB is intervening in the monetary policy of banks. If the loans go bad, the ECB itself will be partly liable. It could then find itself obligated to help the banks.

In the end, Mr. Draghi just wants to prevent the banks from merely buying government bonds without lending money in turn.

That may be true. But if you consider that the economy on the whole is ailing because there is too much debt – among private households, businesses, banks and governments – it seems doubtful that intensifying lending can improve the situation in the long term. Serving liquor to an alcoholic suffering from withdrawal symptoms might make him feel better in the short term, but it makes recovery even more difficult.

Does this mean that a debt relief strategy is needed to overcome the crisis?

Exactly. Bank debt plays a central role in this context. Empirical studies show that debt-ridden banks in the euro zone issue relatively fewer business loans and buy relatively more government bonds and capital market investments than banks with less debt.

So you advocate more equity financing for banks?

Absolutely. And to a much greater extent than today. Without a significant improvement in the equity financing of banks, our financial system will always be at risk. In the long term, the equity portion of bank financing should be raised to 20 to 30 percent of assets, or 10 times as much as the two to three percent that was common before the crisis, or the 3 percent required under Basel III.

The banks use the opposite argument, namely that a higher equity ratio would come at the expense of lending.

The behavior of banks in the euro zone shows that the opposite is true. By the way, the biggest drop in lending occurred in the fourth quarter of 2008, and it wasn’t because equity capital requirements were too strict, but rather that they were too lax. As a result, the banks were brought to the brink of insolvency due to losses on U.S. mortgage-backed securities.

Why does it have to be as much as 30 percent?

That’s what banks require of their borrowers, including hedge funds. Why should major banks invest less of their own money than hedge funds, where much of their business is similar? With institutions like Deutsche Bank and BNP Paribas, loans now make up less than half of investments.

Isn’t it in the end the continued liquidity assistance and the low benchmark rate that deters banks from borrowing capital?

Yes. In the 2008 crisis, taxpayers rescued almost all banks. But we have a problem of excess capacity in the banking sector. Because ailing banks are being kept artificially afloat with government funds, competition is so intense in some cases that the banks can only survive in the market by gambling. And solvency is also at issue in many instances, so that banks have trouble recapitalizing on their own. Low interest rates exacerbate the problem, because margins are also low, which adversely affects earnings. And if cheap ECB loans also benefit the zombies, that is, the banks that are actually insolvent but are not being shut down by the authorities, the structure doesn’t change.

Is it possible to clearly delineate where the liquidity problems and where the solvency problems lie?

No, that can never be clearly delineated. Still, it’s useful to at least draw a mental distinction between the two. Lending to zombie banks is problematic. As we saw in the United States in the 1980s and Japan in the 1990s, these kinds of banks cause enormous damage. Strictly speaking, the central bank shouldn’t be lending to insolvent banks at all. But what should it do when insolvency is hidden, because regulators tolerate the bank’s assets – loans and securities – being reported at unrealistically high values?

So the solution is to quickly resolve the problems, even if this is especially painful in a crisis situation?

Yes. That’s what Sweden did in 1992, and the result was that the country initially went into a very severe recession but then managed to emerge from the crisis very quickly.

Now the ECB is in the process of identifying poorly capitalized banks. In the space of a year, it is reviewing the banks’ financial statements and performing a stress test. Is this even feasible, given the short timeframe?

Not really. To be able to credibly evaluate what’s in a financial statement, you have to look at each individual loan, and that would take far too long.

In that case, isn’t the outcome shaped primarily by political considerations?

Certainly, to some extent. Because we still lack a functioning mechanism for liquidation, it comes down to whether the countries in question can cope with the problems that may be discovered. If the problems are too big, they might be swept under the rug, as has been done in the past. On the other hand, the ECB has an enormous interest in avoiding bank failures within the first 15 months of assuming its supervisory role.

Shouldn’t the ECB be pleased that the case of the impending bankruptcy of Portuguese bank Espírito Santo has now come to light?

Perhaps. It means that the problem is off the table for now. On the whole, I expect that problems will be discovered with some banks, but that they will be limited and therefore manageable. For reasons of proportionality, one or two German banks will certainly be part of the mix.

Just because it’s politically opportune? That alone suggests that perhaps the stress test doesn’t comply with scientific standards…

It doesn’t have much to do with science, but rather with the evaluation of loans and securities positions. I also believe that these problems also exist among German banks. There is always a certain amount of latitude when it comes to evaluating creditworthiness. But in the end it’s not a matter of political correctness or incorrectness, but of solving the worst solvency problems.

Is Germany’s financial supervisory authority, BaFin, insinuating that the ECB is basing its analysis on blanket assumptions?

I wouldn’t overemphasize that. The bottom line is that everyone involved knows that precision has its limits, and that many things are based on discretion. All of the players here are performing their respective roles. The ECB wants to show that new brooms provide a clean sweep. National regulators, for their part, don’t want to be accused of sloppy work.

But it’s role-playing games based on imprecise science that may lead to a bank’s liquidation. Shouldn’t shareholders complain?

Ordinary bank supervision is also based on imprecise information. I don’t see any difference between the two. Besides, my fear is that the examination will be too lax, as it was in 2010 and 2011, when banks that had passed the European Banking Authority’s stress tests with flying colors became insolvent soon afterwards.

Mr. Hellwig, thank you for this interview.

The interview was conducted by Jens Münchrath.

Martin Hellwig is the director of the Max Planck Institute for Research on Collective Goods. He was born in Düsseldorf, studied economics in Heidelberg and has a PhD in economics from MIT. From 2000 to 2004 Mr. Hellwig was the chairman of the German monopoly commission.

Jens Münchrath is a Handelsblatt senior editor in Düsseldorf. He writes about economics and monetary policy. Contact the author: muenchrath@handelsblatt.com

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