Banking System: What Are We In For? – Interview

Fredrik Erixon, the Director of the European Center for International Political Economy, about global economic recession and downgrading of credit ratings of Spanish banks.

Basically, since this is a nasty surprise, I’m referring to the downgrade of those credit ratings, but how bad is the downgrade?

I’d put it like this it is perhaps not as bad as it looks like. The downgrade itself is probably not as bad as it looks. The banks in question are some of the biggest banks in the world and they are of course affected by the global economic recession that we are seeing right now with narrow economic activity, with fewer clients that are asking them for the services, so they are seeing their profitability going down.

So, in that sense I think it is not as bad as it looks but we need to put this in a perspective and of course the perspective is that we are right now in a situation which is probably going to become much worse than it is today. All the economic indicators right now are basically suggesting that we are heading for a downturn not only in Europe but also in Asia, in North America and perhaps in other parts of the world as well which means that all the major liquid markets in the world are going to go down and perhaps they are going to also go down severely, especially in Europe where there is a risk for Greece exiting the euro and where we see the same problems in Spain and Italy, and some of these problems are indeed connected to banks as well.

So, we are right now on the doorstep of a global economic recession which is going to become even worse. And when that happens of course the conditions for the banks are going to become even worse as well. So, this may be just repercussive of new problems to come for the banks. This might be the first of several downgrades that are going to come for these banks in the next, let’s say, one or two years. Banks all around the world are heading for much tougher conditions with the problems of economy that we are seeing and when that happens they need to adjust to it.

Interestingly enough, I have heard that the Spanish Government has been considering an option of giving money directly to the banks. Could that have worked if that had ever happened?

The Spanish banks themselves need to be recapitalized in many different ways. What we have seen recently is the Spanish Government injecting capital into one of the banks in Spain and since then we also had an agreement among the Eurozone governments that they all going to give a special bailout package to the Spanish Government in order to recapitalize the entire banking sector, not only one bank sector. And yesterday we had independent auditors that had looked into the conditions for Spanish banks and they came up with two different figures suggesting that in the worst case scenario Spanish banks need injection of capital, basically equities, to June of 50-60 billions of euro.

So, what we are going to see very soon I think is that the Spanish Government is going to make a formal request to the Eurozone to get this sort of package. And that basically means that you are going to see a government injection of money into these banks in order to make them more stable than they are because the situation in Spain has been alarmingly acute in the past weeks because the banks themselves are in trouble. And the problems in the banking sector are causing many investors and others to worry about also the status of the Spanish Government and its capacity to basically borrow money on private markets in order to cover its fiscal deficit because there is a very strong intimate relation between the Spanish banks and the Spanish Government with many Spanish banks sitting on the Spanish Government’s bonds and use them as a collateral when they are taking up loans from the European Central Bank and from others.

So, what we’ve seen over the past weeks that is a situation where the Spanish banks are becoming almost locked out from normal private capital markets and have difficulties to make a normal business with others banks. And the bank market for these banks has opened close but it’s become much more difficult for them to deal with other banks. This of course is also having strong repercussions on the real economy of Spain because if you don’t have a banking sector which is working normally, you will of course see that businesses and households will have difficulties to take a credit and they will also have difficulties to make exchange with other parts of the world, to trade because all that sort of trade of course is going to be channeled through the banking system. And if other banks around the world have difficulties dealing with the Spanish banks because they are afraid about the commissions of these banks, then this sort of normal trade becomes much more difficult.

So, it is absolutely necessary to find a way to recapitalize the Spanish banks on the equity side and when they do that hopefully and probably we will also see that the refinancing commissions for the Spanish banks and on the private capital markets also will improve.

But does this is a country’s specific approach, do I get it right?

Yes, it is. I mean it is a country’s specific approach in the sense that your equity is going to be injected by the government into these particular banks. But then you of course have many other policy tools that are not specific for Spain itself, I mean we’ve had, just to say for an example, two rounds from the European Central Bank when they have offered extremely generous credit to banks to refinance themselves because of the difficulties to do that on the private market.

So, roughly a trillion euro, a little bit more than a trillion euro actually, has been lent to European banks and northern Eurozone banks. But with European banks, starting from late December and then in February this year, we might see that the ECB need to do the third round of this type of lending to the banks because when they have difficulties to take up these types of loans on private capital markets, when the borrowing costs for them are soaring, as we have seen they have done, that also has a direct effect on the real economy because these increasing costs are of course going to be immediately transferred to the real economy.

Mr. Erixon, are there any local markets that would be least affected by the crisis?

You mean on the financial banking side?

Yes.

I think there are markets of course that are going to be less affected than the others. If we look for instance back to 2007-2008, it was quite clear that for instance some of the Asian markets weren’t as affected by the financial meltdown as the United States and Europe partly because their banks and financial institutions were not as exposed to the global financial markets as the Western financial institutions. And I think this is equally true today even if you never can be entirely protected from giant financial earthquakes in other parts of the world, you can at least be less exposed to it than the others. I think it is also true for some of the banks in other parts of the world as well but no one is really as protected as they need to be in order to weather a giant financial crisis, I mean if that was going to happen there will be repercussions in all the parts of the world.

Sure! But if we look at the recent decisions of the G20, they were coming up with one of the potential solutions of increasing the lending capacity of the IMF largely owing to Chinese banks and other oriental banks. Do you think that this is a viable approach?

The new capacity of the IMF I think is necessary in order to single some sort of readiness on the part of the world to deal with not only potential meltdown in the financial sector but also because of the problems with especially the European governments that are on the brink of defaults. And the two governments that are in the most stressful situation right now are Spain and Italy. And the new firepower on the part of the IMF I think should be seen very much in that particular context. It is a potential help to the governments, not to financial institutions themselves when some of the money that may be lend to governments can be used also to cheer up the capital position of financial institutions and banks. But predominantly the IMF gives resources to governments and sovereigns in order to help them in a situation when they are about to default. So, the money itself that the IMF sits on is not really a capital base to use it for the banking sector, it can only be indirectly used in that sense.

What about another solution, like they said they wanted to expand and perhaps improve the operation of trans-European financial institutions, is that going to work?

We are talking about different things, I mean some of the work that has been done recently partly on the G20’ side and partly on the European side concerns the capacity of institutions like the European Investment Bank. To increase the capital base for that bank could take up more money and consequently lend more money to especially private companies in Europe. This is very likely to happen but it is also very likely just to have a marginal effect on the overall economic activity and economic growth in Europe simply because the money that is prepared to increase the EIB isn’t very much and it is only going to lead to an increase, in the best scenario, of 40-50 billion euros and that is not very much in a 13 trillion euro economy like the EU.

So, it is only going to be marginal use and of course the sort of investments that it is looking at, they are investments that tend to have at least medium term effect on economy, in most cases it has a long term effect on economy. But it is not something which is going to help economies in the short term because investments that you are doing today, you want them to pay off five years from now, perhaps ten years but not tomorrow or the next year. So, even if it is a step in the right direction, there is only going to be a marginal use.

But then, just theoretically, what would be the optimal solution?

I’m not so sure there is an optimal solution. I think one of the problems, especially if we look to the Eurozone, is that the governments have missed so many opportunities to do the right thing and we are now on the third year of the Eurozone crisis itself, we are of course five years into the global financial crisis, but three years into the Eurozone crisis, and that means we are three years into missed opportunities.

So, the problem we are seeing right now is that if we have done the right things in 2010 when we were in a situation of having to sign a bailout package to Greece, the first bailout package, if we’ve done the right things then the total costs for any activity would have been much lower than what we basically need to do today. I’ve been arguing for some time now is if it is basically a three prone prep strategy. The first strategy is that there must be more capital available to help governments that are on the brink of default, especially Spain and Italy because if they are defaulting we are in fact talking about a collapse of the entire euro cooperation. And it is not happens, we are going to have catastrophic consequences not only for the European economy but for the world economy.

So, it is absolutely important to avoid that situation. And when you look at the financing needs of Italy and Spain, you can immediately see that these volumes of money that you cannot raise through the European member states. For them to pay that sort of resources into the European stability mechanism, my argument is that the only actor with pockets deep enough in order to be prepared to weather a strong financial storm coming from Italy and Spain, that is the ECB and we need to see greater activity on the debt markets of the ECB. This is my first line of defense.

Secondly, we need to see much stronger focus on structural economic reforms in those countries that are in difficulties – Spain, Italy, Greece, Portugal and many others. What we have seen recently of course is that some of the governments have diligently pursued reforms on a fiscal side and to some extent also on the real economy side. But we need to see much more structural economic reforms that are going to increase a competitive growth in these economies.

And thirdly I think we need to look at some institutional changes in the way that the European financial sector is being regulated and being surveilled basically in order to get much better control of what they are doing. And I’m completely in favour of this new drive which is to create some sort of a banking union in Europe. I don’t think it is possible to create a banking union which is going to have what they are calling a deposit insurance scheme which is pan-European. I think that’s possible but at least we can get them regulated on a central basis and get them also surveiled on a central basis. And I think that would be a huge step in the right direction.

Mr. Erixon, thank you so much. And just to remind you our guest speaker was Fredrik Erixon – the Director of the European Center for International Political Economy which is a world economy think tank based in Brussels.