Politicians and officials have been burning the midnight oil trying to reshape the architecture of crisis prevention and crisis management for Europe’s financial sector.
Apart from the sidelined (and limited) Liikanen report, however, precious little effort has been devoted to the question of whether or not the structure of Europe’s financial market is fit for purpose. It is not, as a recent analysis from the Group of Thirty (G30) shows. The G30, confusingly, has nothing to do with the G20 or the G7. It is a high-level, quasi-official, financial-sector think-tank, chaired by Jean-Claude Trichet, former head of the European Central Bank (ECB) and before that of the Banque de France.
One of the G30 report’s most controversial conclusions is that some of today’s pariahs in parts of the so called “casino” or “shadow banking” sector must now be seen as part of the solution to Europe’s growth crisis. They cannot simply be vilified as a cause of the region’s problems. It calls, for example, for steps “to implement reforms….to transform shadow banking into resilient market-based finance”.
According to an ECB paper, the usually lightly regulated shadow- banking sector includes hedge funds, money-market funds, the re-purchase agreements market and certain forms of “securitisation”, the process of bundling assets into a bond or security.
Defenders of shadow banking have argued that they had nothing to do with the financial crisis – and that therefore they do not warrant the stricter regulation for which the European Commission has been pressing.
A report published recently by the Commission’s department for economic and financial affairs, “Non-bank financial institutions”, shows that such arguments are spurious and self-serving.
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But the aim of the report’s authors – it was commissioned from independent consultants London Economics – is not to condemn shadow banking outright. Graham Bishop, one of the authors of the report, says: “It is time to stop demonising so-called shadow banks.”
Many politicians, including MEPs, have been smelling blood in the past couple of years. Because they are angry at the contribution of some lenders to inflating the bubble economy after 2002, they have been pushing for, in effect, punitive regulations to be imposed on banks and shadow “casino” banking.
Tighter regulation is needed, but it should not be punitive. Paradoxically, given the United Kingdom’s Eurosceptic mood, and given the central role that market based rather than bank based lending plays in London’s international financial centre, it could be the biggest beneficiary of any shift towards diversifying the EU’s financing structures.
A clue to the inadequacy of Europe’s financial system is provided by a comparison with the United States financial sector’s quite swift recovery from the post-2007 financial crisis.
There are many reasons for this economy-boosting recovery, to which I devoted a column three months ago (“The great global rebalancing act”, 29 November-5 December 2012), but too little attention has been paid in the EU to one of them. The structure of financial markets in the US is radically different from that of the EU. (Germany is a special case, but in this instance the UK is not.)
As the G30 report points out, in the US only 19% of longer term corporate finance is provided by banks. The rest comes from capital markets, including the bond market. In Europe, including the UK, precisely the opposite is the case. Banks dominate lending to companies and households, providing, according to ECB figures, as much as three-quarters of non-financial companies’ financing needs.
Unsurprisingly then, the worst banking crisis in modern history, which is crippling a too-dominant European banking sector, is hitting Europe’s bank-dependent companies and households, impeding economic revival.
Simply put, the banks are so busy pulling in their horns to recover from the losses that they inflicted on themselves by their excesses in the bubble years that they are holding back growth in the wider economy.
In its last financial stability report (October 2012), the International Monetary Fund (IMF) estimated that from late 2011 to the end of 2013, EU banks are likely to reduce their assets by 7%, or €2.8 trillion, as they reduce their risks, strengthen their finances and adjust to justifiably tighter regulation and supervision. Investment banker Goldman Sachs has just pointed out that, across the eurozone, lending by banks to companies has now been declining for six consecutive months.
Tougher corporate lending conditions have hit troubled countries on the eurozone’s periphery particularly hard. The financial climate in Italy will not have been improved by last week’s indecisive election.
Meanwhile in London, just days after the UK lost its prized triple-A credit rating, a desperate Paul Tucker, the deputy governor of the Bank of England, signalled official distress about the impact on companies – and so on economic growth – of the bank lending squeeze.
He even floated before the British parliament the astonishing idea that in order to put pressure on banks to lend to the private sector they should be forced to accept a negative interest rate on cash that they park in the central bank.
The G30 report “Long Term Finance and Economic Growth” points out that since 2007, annual net new bank lending to companies in the EU fell from €650 billion to €40bn in 2011.
It then highlights the stupendous sums of money that the world’s nine largest economies now need to invest to sustain growth. Spending on factories, schools, education and research will have to soar in inflation-adjusted terms from $10.7 trillion in 2010 to almost $19 trillion by 2020, it says.
It points out that bank lending, even when it is readily available, tends to be short term and so unsuitable for financing the long-term infrastructure projects, research and development and education initiatives that are needed. In the past, the report says, governments have provided significant volumes of such funds. Over-indebted governments will now be unable to do so.
For these and other reasons, particularly in Europe, new institutions and financing structures are needed. “Expanding Europe’s corporate bond and securitisation markets to the same level of those in the United States could free-up more than $300bn in Tier 1 capital for European banks,” the G30 says, so strengthening the banks.
A changed, flexible regulatory/supervisory framework to oversee but not inhibit financial innovation will of course be needed. The IMF, in a recent report, suggests that targeted tax changes could help. Competition policy might have a role to play too.
If a restructuring of Europe’s financial system is to happen, however, politicians will first have to be convinced that those parts of the financial sector that have recently shown themselves to be reckless and irresponsible are now capable of a positive and responsible contribution to the common good.
Stewart Fleming is a freelance journalist basedin London.