Back To The Future? From Bail-out To Bail-in

At the beginning of 2016, the European Union agreed new rules for bank bail-ins. This new era in policies to combat financial market crises came after a long period characterized by bank “bail out” interventions.

In 2008, less than two weeks after the Lehman Brothers’ bankruptcy, Europe started facing a similar crisis to the US one. This happened just a few days before the Bush administration launched the initial measures of the Troubled Asset Relief Program (TARP) and kicked off purchases of those securities held by financial institutions whose value was canceled after the subprime loans crisis.

Interventions set up in Europe in order to support European banks were timely as never before. Their crucial features were:

1. The domestic characterization;
2. The public source of the aid;
3. The prevalence of capital injections with no structural constraints on the institutions benefitting from the bail-out.

 

According to recent estimates from Mediobanca, European countries allocated net interventions, in the form of (re)capitalization, guarantees, credit and/or loans – net of returned or given up items – equal to more than €1000bn. Over 253 of these were destined for Spanish banks, 156 for British institutions, 110 for Irish banks and more than 80 for German and Italian banks. This financial transfer has no precedent in the history of our continent: the European Commission estimates that since the beginning of the crisis EU countries have been acting on behalf of 112 national banking institutions.

Looking at these interventions, one question may arise: can the philosophy of such bail-outs be related to the Keynesian vision of economic policy or to any other ‘unorthodox’ vision?

The answer is certainly negative for two reasons at least.

First of all, the interventions carried out in order to support banking institutions were not characterized by selective evaluations of their work which should have been essential in order to distinguish between illiquid and insolvent banks. Furthermore, European supervisors and regulators, both national and supranational, have never questioned the pernicious mechanisms that exist in the financial markets and have never questioned the propensity to generate and accumulate risk instead of minimizing it and controlling assets, such as derivatives, that may be carriers of systemic instability.

Secondly, the seriousness and knock-on effect of the subprime crisis should have triggered a Keynesian Resurgence in favour of a different approach to monetary and fiscal policies, after a 20-year surrender to stultifying economic liberalism.

If any resurgence did occur, it was short-lived since there has been no structural re-think of the limits of mainstream economics subsequently.

Actually, some critical notation or doubts did arise towards the end of the last decade. In early 2008, Dominique Strauss Khan, then director of the International Monetary Fund, aspired to trigger a coordinated fiscal stimulus; in March that year Martin Wolf claimed “if you have an unregulated financial system you are going to get financial crisis”; Robert Shiller kept mentioning Keynes; Joseph Ackermann (then Deutsche Bank CEO) stated: “I no longer believe in the market’s self-healing power” and Alan Blinder estimated 5-6 extra percentage points for US unemployment without expansive fiscal policies.

However, the Keynesian resurgence ended quite rapidly. In 2009 a number of economists, led by Nobel Prize-winners such as Buchanan, Prescott and Smith, signed a manifesto against Keynesian fiscal policies; Robert Barro, recalling the assumptions of the Ricardian equivalence, predicted fiscal multipliers close to zero.

The liberal restoration closed ranks and critics of Keynesianism significantly spread again: “Keynesianism is just a convenient ideology to hide corruption and political patronage,” wrote Luigi Zingales with renewed self-assurance.

While early in 2009 the United States launched a multiannual program of increased public spending, known as the American Recovery and Reinvestment Act, in Europe the Keynesian interlude was dismissed out of hand. In 2010 the European Central Bank announced:

the fiscal exit from the crisis must be initiated … to be followed by ambitious multi-year fiscal consolidation. This is necessary to underpin the public’s trust in the sustainability of public finances. The Stability and Growth Pact constitutes the mechanism to coordinate fiscal policies in Europe … Sound and sustainable public finances are a prerequisite for sustainable economic growth and a smooth functioning of Economic and Monetary Union. (ECB, 2010, p. 7)

Starting from that moment, a schizophrenia in European economic policy emerged and after five years we are inheriting it in its entirety: austerity fiscal policies aimed at maintaining a balanced budget, expansionary monetary policy alongside infinitely elastic aid and bail-outs to the banking system.

This policy mix is not new in the history of Western economies. Indeed, a few years ago Mervyn King, ex-governor of the Bank of England, admitted that the greatest fear of a central banker is not inflation but the public deficit trend. The novelty lies in the unconditional policy guidelines to intervene in favor of the banking system, whatever the effects in financial terms to the taxpayer are. These policy guidelines were adopted by both national governments and the ECB.

Such unconditional support to the financial system deserves particular attention when analyzing European policy in the aftermath of the international crisis. Researchers who wish to identify the reason for this phenomenon would probably find multiple causes. Some of them may be reasonable, others are determined by debatable interpretive hypotheses, and finally still others probably have less noble intentions.

It is worth starting from the reasonable causes. When the financial crisis began, in the main Systemically Important Financial Institutions – namely the institutions that work cross-border with endless subsidiaries in several financial markets, with an asset portfolio that often exceeds the GDP of some countries – the “too big to fail” principle should have been supported by the “too linked to fail” principle. That is why the fear of the domino-effect through the financial institutions, which are at systemic risk, has been at the basis of the bail-out since 2008.

It would be helpful to explain why such a correct justification for intervention has not been accompanied by a rethink of the governance of these institutions, and a more effective legislation to guide their behavioral modalities in financial markets.

The unconditional support for the banking system can also be explained by: (i) the idea that banks would have suffered from the crisis of sovereign debt in euro area countries; ii) the belief that the soundness of the big credit institutions is a precondition for an ongoing monetary union. These are legitimate but controversial assessments if we think that the banking fragility was not only an effect but even the cause of the fragility of sovereign debt since the ruthless use of and speculation on sovereign credit default swaps had negative repercussions on governments’ credibility.

During his frequent disputes with the German Chancellor and Bundesbank President Jens Weidmann, the ECB President claims that the strengthened capital basis of banks ensures successful conditions in the medium- to long-term within the EU; while this opinion can be shared, this does not imply systematic compliance with the needs of the banking world.

In recent (2014) research by the Corporate Europe Observatory, it was hypothesized that the lack of reform of governance in the European financial marketplace has been caused by successful campaigns carried out by the financial lobby in the EU The belief that the business community exerts both undue and due pressures on the legislative and executive powers that be is a frequent leitmotif of the reconstructions of the link between politics and finance. Today it seems that these links in Europe are similar to those experienced in the American system.

Across the Atlantic, the activities carried out by the Financial Services Roundtable, which represents the biggest financial services companies, and by the International Swaps and Derivatives Association, have been widely documented. Both of them turned out to be crucial in order to minimize the repercussions of the crisis following the Lehman Brothers crash on the financial community and subsequent legislation.

What may be totally new to European researchers is to realise that in the EU’s bodies in Brussels there are 1700 lobbyists working for and more than 700 organisations representing the banking and financial community, such as the British Bankers Association and the German Banking Industry Committee.

Whatever the role of these lobbies, centrality of and support for the banking system form one of the pillars of the policy mix adopted inside the European Monetary Union; at the opposite end of this spectrum, there are the principles of austerity. These two sides are incoherent, analytically unfounded and socially deleterious.