European Union & Banks
The banks act as natural intermediaries facilitating the flow of funds in open economies of the Euro zone. Some countries like Belgium have a structural surplus and are thus net exporters and some countries like Netherlands have a deficit, and their banks are net importers. The open market economy in the Euro zone is structured to increase the free flow of funds and credit, efficiently balancing out monetary supply and demand across the union. In principle, this mechanism should prevent net exporters from developing bubbles and net importers from enduring credit crunch periods. Banks like Santander are necessary for the open market economy to function in the Euro Zone. They are effectively too big to fail in the current environment.
The banks are spinning their wheels but they are essential to the Zone
The ECB instituted 2 3-year liquidity operations performed at the end of 2011 for the total amount of over $1.3 trillion. The goal of this action by a lender of last resort was to ensure that the euro banking sector avoided a credit crunch. As a result, the majority of those funds were used on the inter-bank market, with a small minority passed on to the retail sector. Total loans in the European Union equaled $31.85 trillion and in Euro Zone $24.05 trillion. Total assets in EU were $60.3 trillion and in the zone $43.68 trillion. Governments and non-financial corporations are clear net borrowers in the EU-27, while other financial institutions and Insurance Corporations and Pension Funds are net lenders. Households and other Monetary Financial Institutions are about equal on borrowing and lending. Banks preferred to deposit excess liquid funds at other banks’ accounts instead of lending them out in the real economy. Part of this behavior can be attributed to tighter capital requirements, economic turmoil in Europe, and excessive credit risk assessment with low net interest margin, which averaged anywhere between 2-3% for most banks in 2012.
On June 28-29, 2012 European leaders gathered to discuss the possibility of a European Banking Union with a single European Deposit Guarantee Scheme (somewhat like the FDIC insurance), single supervisory authority, and single Crisis Management Framework. The authority power was given to the ECB and the supervisor will be phased in during 2013.
EU-27 generated $277 trillion in non-cash transactions in 2011. Bank account debits, credit card payments, and wire transfers constitute the largest three types of transactions with wire transfers representing 89% of value. A credit crunch in the Euro Economy would have dire consequences for businesses.
Small and Medium Enterprises (SMEs) drive economic growth – 99% of companies in the EU are SMEs. During the economic crisis the demand for products softened, lengthening payment terms from the customers and eroding working capital. This prevented SMEs from making capital investments and forced a slowdown in finance demand, damping growth prospects. 75% of corporate funding in the EU is obtained from the banks, as opposed to 30% in the US; therefore the EU has a bank based capital model. Therefore, larger European banks must survive to avoid systemic collapse. Santander is the largest Euro Zone bank and if it fails, economic consequences will be dire.
There is strong political commitment to the European project. It’s in nobody’s interest to break up. Decision process is slow but countries will do what it takes to keep the project on track. Economic adjustments are now underway. Spain has some of the lowest unit labor costs in the Eurozone, helping its competitiveness:
– Fiscal adjustment (taxes and gov’t spending)
– Competitiveness adjustment
– Demand expansion in Central Europe
– Monetary support (money supply through variety of tools including interest rates, discount window, open market operations, signaling, QE, currency pegs, and reserve requirements)
Spain has the following issues that are being addressed:
1. Loss of competitiveness (almost as competitive per unit of labor as Germany)
2. Current account deficit (improving and will be a surplus in 2013/14)
3. High fiscal deficit
4. Structural rigidities.
5. Need to clean up the banking system’s balance sheet (doing so now, like with Bankia)
Political reforms in Europe include a banking union which will have a single supervisory mechanism with a single deposit guarantee fund. This will cut the link between sovereign risk and banking risk. This is good for Santander because it will put an additional degree of separation between Spain and the bank. Nonetheless, the key for SAN’s success is based on diversification, cost control, liquidity management, and risk monitoring. For Santander, emerging markets will offer significant opportunities in the next decades. The bank is very well positioned in Latin America. Brazil along with Mexico should be in the top 10 economies by 2030 with a combined GDP of 18.8 trillion (12.2t Brazil).
What about bailouts
What causes a bailout? There are two main components to a bailout – governments and the banks. If a government’s sovereign bonds are considered junk, with a very high yield and a possible risk of default, the government may drag down the banks of that country because the banks sold the bonds, requiring a bailout. The banks on the other hand, can also get themselves in trouble through their operations in the residential mortgage space, commercial loans, and other bad transactions causing write-downs and insolvency which require a bailout.
For this purpose, a banking union may be a positive political stabilizer. Santander executives agree. It would be needed for bailout funds, deposit insurance, and euro-wide supervision and it would decouple the governments from the banks. The responsibility for the bailouts would fall on the euro zone as a whole. However, the debt-sharing potential may be a turnoff for the wealthier countries because it will effectively subsidize the weaker nations. Sovereignty is considered fair and mitigating it is unlikely, considering the various cultural and language differences. The union isn’t similar to the United States of America where people have a common denominator in the language and loyalty to one flag.
Maybe dropping the Euro is the answer
So the question stands, wouldn’t it be easier to just abandon the single currency? Probably not, the political and fiscal union should be maintained somewhere between a fully independent/individual country base in Europe and a completely integrated United States of Europe. Sovereignty and nationalism matter, and people will not give up their identity for the full political and fiscal union. The answer to a successful union lies in the middle and must contain the following:
1) flexible markets with commerce flowing freely across borders,
2) adequate lender-of-last-resort mechanisms for solvent lenders and countries
3) creditors of insolvent banks and governments have to be forced to take haircuts to level out upside with downside.
What happens when one or two large European countries are in deep trouble? How can Spain and Italy be firewalled? The ECB can print money and provide it to Spain and Italy (in form of bond buying), driving down their borrowing costs. Another possibility is increasing the funds available to the zone’s bailout fund headed by Draghi (again ECB would provide the money), but it’s essentially the same thing – the fund is the middle man in the transaction. A third idea is to have the strong countries make direct interest subsidies to the weaker ones in return for reform programs. Sure, Germany’s and other strong countries’ citizens may be appalled at the rescue, siting that Southerners’ demise shouldn’t be an anchor around their own necks. Furthermore, inflation would eventually pick up if money supply is increased, but isn’t it much better for Spain and Italy to weather the storm and become productive European players that would purchase goods from Germany and others? The Euro countries are all in the same boat and the least prudent course of action would be for the healthy passengers to puncture a hole in the boat to teach the sick ones a lesson.
The Greek exit example, it can’t be good
Let’s explore the scenario of a European nation like Greece leaving the Euro. What would happen? First, there are 17 zone members and another 10 countries in the union who use their own currency. If Greece was to think about leaving the Euro, it’d have to discuss it with all the members and probably in its own parliament – a process likely to take months. Of course the reason for leaving would be to devalue its currency and make the economy more competitive. This would mean that people invested in the banks would undoubtedly attempt to withdraw their funds in fear of significant wealth erosion. A stampede would ensue, and since the banks are highly leveraged institutions, potentially only one Euro for every thirty owed could actually be withdrawn (depending on capital ratio). If the people were to leave the money in the bank, they would wake up to a potential purchasing power loss of 50% upon conversion of euros to Drachmas.
If Greece left the Euro, it would decimate its own economy. By switching to the drachma, it will print money and re-price all goods on the market, including unit labor costs to become more in-line with the supply and demand equation. The oscillation, or more likely, a total cliff dive in the currency would not cease until a balance point is discovered. Inflation may balloon out of control and political unrest over undercapitalized banks with high unemployment would consume the country leading to poverty and flagrant crime rate. That would be prime ground for an unconventional government to claim power, and that would not benefit the population. Greece could then do one of 3 things – allow the banks to collapse, call on Euro partners for help, and limit withdrawals. It can’t allow banks to fail – that would be Armageddon. Euro partners would only help if Greece stayed in the zone and the ECB could let Greece central bank to provide liquidity with Athens on the hook for any losses. Greece could limit withdrawals, but that would cripple the economy because it would ration capital for all businesses and credit – the lifeblood of all enterprises – would slow down to a trickle (Cyprus anyone?).
On the positive note, tourism may pick up thanks to half priced offerings and the economy may rebuild out of the ashes, more competitive than ever. But how would the government finance itself to get there, and what about inflation? Its’ current debt is 183% of GDP and if it devalues drachma it’d go to 366% of GDP. It has a current budget deficit, bringing in less than it spends, even before interest payments. If it defaulted across the board – it’d become a pariah state. It’d have to negotiate an orderly default with the IMF forgiving some but not all debts. It could get some hard currency in return to manage the transition with the promise of reform.
The contagion resulting from the Greek default and Euro exit would cause the savers in Spain, Ireland, Portugal, Italy and other weak countries to run at their banks, take the Euros and put them in stronger places like Germany and Denmark. ECB would have to authorize an unlimited printing spree to subdue the panic. The solution to the madness would have to come from the ECB – uncompromised liquidity as a lender of last resort to countries committed to the zone, orderly exit for specific countries that want to leave the Euro (though so far no one left), and rationing access to savings during that transition (like in Cyprus).
How can the Euro survive?
- Insolvent entities, government or banks, should have their debts restructured. Creditors will take a hit immediately, but it will stem systemic crisis. In Greece, the bailout took too long and eventually the creditors were spared losses but the IMF and the governments will be left holding the bag when the defaults on debts do occur. About 74% of 274 billion Euro Greek debt is with those entities. Taxpayers will pay. If the restructuring occurred earlier, some banks would have holes in the balance sheets that would need to be filled by further bailouts, but the hits could be absorbed.
Insolvent banks shouldn’t be bailed out. Creditors should take the losses before taxpayers.
- Liquidity backstops for banks and governments that are solvent. For banks, it’s the ECB, for governments it’s the European Stability Mechanism – bailout fund of the zone. It could potentially borrow from the ECB.
An example here is bank Santander, where most of the Spanish banks took a bailout from the ECB and Santander took 35 Billion Euros. The bank was and is solvent, and returned over 20 Billion so far.
- Flexibility in the labor markets is necessary.
In conclusion, I think that the European Union and the EURO will survive the current economic recession. Draghi signaled that the ECB will do everything to make that happen. People of different races and languages can coexist in a union if their well-being is tied closely together – as is the case in the Euro Zone. The underlying differences will cause friction, no doubt, but Europe is safer when it’s together. The European banking system will be essential in helping to overcome the prolonged downturn, and Santander is an integral part of the group. It will rise when the sunny days return. In the meantime, the bank’s geographic diversification will serve it well in weathering the storm.