Daniel Rodríguez

These days, we hear a lot that banks were the problem in the 2008 crisis and now they are the part of the solution. 

Banking was not the main problem of the 2008 crisis, but one of the symptoms that indicated a more serious disease, the excess risk taken by public and private economic agents after massive interest rate cuts and direct incentives to take more debt coming from legislation as well as local and supranational regulation. Lehman Brothers was not a cause, it was a consequence of years of legislation and monetary policies that encouraged risk-taking.

The second part of the sentence, “now banks are the solution,” is dangerous. It starts from a wrong premise, that banks are stronger than ever and can bail out the global economy. Banking may be part of the solution, but we cannot place, as the eurozone is doing, the entire burden of the crisis on the banks’ balance sheet. I will explain why.

When economists in Europe talk endlessly about the differences in growth and success of monetary and fiscal policy between the United States and Europe, many ignore two key factors. In the United States, according to the St Louis Federal Reserve, less than 15% of the real economy is financed through the banking channel, in the European Union, it is almost 80%. In addition, in the United States, there is an open, diversified, more efficient and faster mechanism to clean non-performing loans and recapitalize the economy that adds to its high diversification in private non-bank financing channels. 

It is, therefore, essential that in periods of crisis countries, particularly in Europe, do not relax risk analysis mechanisms, because the economic recovery may be slowed down by ongoing problems in the financial sector and even lead to a banking crisis in the midterm. The worst measure that countries can take in a crisis is to force incentives to take a disproportionate risk.

European banking is stronger today than in 2008, but not as healthy as governments would like to believe. In recent years, the banking sector increased its top-quality capital ratios (CET1) at a rate of almost 1% per year despite the difficult economic environment in Europe, poor growth and, above all, negative interest rates that have decimated the sector’s margins and profits. However, a large part of that capital improvement has been achieved by issuing hybrid bonds (CoCos), which should be taken into account when considering hidden risks. CoCos can create a domino negative impact on the financial sector as a coupon on these instruments is paid only if core capital remains above a certain level. If the coupon is cut, the fragile capital structure of eurozone banks can deteriorate rapidly.

More than EUR104 billion of hybrid bonds (CoCos) are included in the calculation of eurozone banks’ core capital.
European banks have been able to strengthen their balance sheet and reduce risk in an environment of margin destruction via negative rates and suffocating regulation. The impact, according to Scope Ratings, has been very high, more than 25 billion euros in lost profits between 2014 and 2018. Analyzing the earnings of the financial sector (SX7E Index) between 2014 and 2019, the net income margin has fallen by 30%, earnings per share have fallen an average of 13% and the capitalization of the sector in the stock market is at record lows.

In such a difficult environment, the sector has reduced its non-performing loans (NPLs) by half to 636 billion euros according to the European Banking Association, that is 3% of total assets (as compared to 1% in US banks) while highest quality capital ratio (CET1) is at 14.8% and total capital ratio at 18.4% with leverage of 5.68%.

In the face of the Covid-19 crisis, European states have launched huge economic programs aimed at businesses and individuals, but the common denominator of all these programs is to exponentially leverage the balance of banks.

In my study “Monetary and Fiscal Policies In The Covid-19 Crisis. Will They Work? ” I explain how most of the European governments have made the decision to massively leverage the banks’ balance sheets through partially or totally state-guaranteed loans. However, we cannot forget that these are loans and that the vast majority go to businesses with enormous difficulties due to the forced closure of the economy, which in some cases means doubling the risk of banks.

Germany, for example, has taken fiscal measures equivalent to 4.5% of its GDP, but bank leverage measures via liquidity lines and loans equivalent to 24% of its GDP. In the case of France, fiscal measures of 2% of GDP and bank leverage ones of 14% of GDP. In Italy, 1.4% and 20% respectively, and in Spain, 1.4% and 8%.

I think the disproportion is obvious. European states are trying to bail-out the economy, closed by government decision, via a huge increase in debt and multiplying the risk on the banks’ balance sheet. The fact that governments guarantee part of these figures neither eliminates the risk nor moderates it, because these guarantees, if executed, will be paid with more debt and more taxes and, with it, less growth and investment.

European governments want banks to sip and blow at the same time. They require them to strengthen their balance sheets in an environment of negative interest rates and burdensome taxation, and at the same time, disproportionately increase credit taking a greater risk with lower profitability. Europe may face a bigger financial problem in the future because, contrary to what most governments expect, the probability of a rapid and V-shaped recovery of the eurozone economy is very low. If the economic recovery is weak and uneven, as is most likely, the rise in non-performing loans and weakening of banks will be substantial, and the impact on the real economy, severe.

Large stimulus is targetting the wrong sectors. Most of the massive loan plans is being absorbed by sectors that were already weak before the crisis due to obsolescence, technology and consumer pattern changes as well as overcapacity.

Another important factor to consider in these huge bail-out plans is the risk of allocating liquidity and capital to those who do not need it in the first place or, worse, to those who should not receive more credit. The vast majority of aid via loans granted by European states focus on sectors that were already “zombified” and with difficulties in 2016-2019, huge conglomerates and so-called strategic sectors that have never had a problem of credit. While zombie sectors are bailed-out, small businesses are dying at a rate of thousands per month. Spain, for example, has lost 122,000 businesses in March 2020, while billions of euro of grants were provided to traditional sectors that had overcapacity before the crisis.

The solution cannot come from huge loans to pay taxes in the future while praying for a V-shaped recovery. It must come through short-term liquidity lines without recourse and tax exemptions during the crisis added to a radical adjustment of non-essential budget items.

Governments cannot ask the real economy to hibernate and drown in debt, or demand large adjustments from the private sector while they keep unnecessary public spending and bloated budgets. 

Countries need to use the fiscal space they have to preserve the productive business fabric, not adding massive leverage, creating a problem in the financial sector in the medium term.

The reader may think that the solution would be a huge public bank that would bail out all sectors. 

The vast majority of productive sectors do not need to be rescued, they need governments to eliminate taxes during the lockdown and lift it quickly. Businesses are not falling due to mismanagement or bad strategies, they are collapsing due to the government-imposed shutdown.

The world has plenty of capital to finance the recovery and strengthen the economy. What the world does not need are politically directed recovery plans. Just allow investments to be channeled efficiently and quickly, not hinder it.

International studies show that public banks have worse solvency and liquidity ratios, in addition to political management. We do not have to remind anyone that two public entities, Freddie Mac and Fannie Mae, inflated the subprime bubble by lending without control and with political criteria to citizens without resources. 

European banks can survive the risks of the Covid-19 crisis, manage the loss of value of their current assets and the rise in non-performing loans, but the banking sector bail-out the entire eurozone economy from the mistakes in health and economic planning of governments.

Fighting the pandemic and preserving the productive fabric are not exclusive objectives. Burdening banks with multiplied risks can create a bigger, long-term problem.

This article was published at The Epoch Times here.

The jobless claims figures of the past two weeks have been unprecedented and alarming. However, knowing that the data will continue to be concerning, we need to analyze how quickly the economy can can heal and go back to the previous path of record job creation.

The United States economy starts from a comparatively stronger base. Unemployment reached a five-decade low in February and, despite the extremely weak March jobs figure, it stood at 4.4 percent in the first week of April. This compares to a 7.3 percent unemployment figure in the euro area and 6.5 percent in the European Union. In countries such as Spain and Greece, unemployment stood at 13 percent and 16 percent, respectively.

The underemployment figure is also significantly better in the United States. The unadjusted U-6 unemployment rate measure was 8.9 percent in March, and a comparable underemployment rate in the European Union would be an estimated 15 percent, and 12 percent in the eurozone, according to Eurostat figures.

The expected rise in unemployment from the forced shutdown of major economies due to COVID-19 containment measures is simply staggering. The International Labor Organization reported that potential job losses worldwide could amount to 36 million. Unfortunately, this figure may be underestimated.

The figure of unemployed in the second quarter of 2020 in the United States could rise to 52 million, a 32 percent unemployment rate, according to the Federal Reserve Bank of St. Louis. In Spain alone, the figure could rise by 5 million, and reach an unemployment rate of 35 percent in our estimates, while temporary and full unemployed could rise to 57 million in the European Union.

The key to a strong recovery lies in the dynamism of the labor market and the strength of the business fabric, but also on a diversified and open mechanism of financing of the real economy.

The United States could recover the entire job losses of a month in a period of one to three months. In the eurozone, this would take a minimum of five to six months, particularly in Germany, which also started the shutdown crisis with an all-time low unemployment rate, at 3.2 percent. Considering countries with higher labor market rigidity, such as Greece, Spain or Italy, this recovery could take between 14 months and two years.

The key to recovering jobs quickly and efficiently is the combination of a flexible labor market, an attractive investment framework, and solid policies to preserve the business fabric of the country. These are the main reasons why the United States traditionally reduces unemployment faster and with better wage growth than the eurozone.

There’s also the issue of disincentives. In the eurozone, excessive intervention in the labor and business environment adds to many entitlement programs that may be counterproductive in a recovery. The European Union spends about 1 percent of GDP per year in “active employment programs” and subsidies, yet the unemployment rate is almost double that of leading economies.

Excessive regulation works as a barrier to investment and job creation in growth times and generates negative incentives to recover after crisis periods. This was evident during the last crisis. The European Union delayed its recovery by four years due to the increased intervention and regulatory hurdles.

The financing mechanism is also key. In the United States, the real economy relies less on bank financing than in most of Europe. The real economy dependence on bank financing in the European Union is close to 80 percent, according to the European Central Bank, compared to 17 percent in the United States, according to the Federal Reserve Board.

This dynamism and openness in financing of business opportunities has traditionally helped the United States boost its economic recovery from a recession, achieving faster growth and more job creation than its peers.

An attractive taxation system is essential to recovering quickly. Unfortunately, in the European Union governments tend to raise taxes on businesses and capital in recession periods, which significantly hurts the recovery process. Legal and investment security are also fundamental in a sustainable and rapid recovery, and, unfortunately, interventionist messages coming from governments generate less inflow of foreign investment and lower growth in gross capital formation.

The recent decision of the Italian and Spanish governments to make dismissals forbidden by law and to intervene in prices will likely prove ineffective, as unemployment will soar anyway due to the destruction of businesses forced to close and will likely harm future investment inflows.

Shutting down the economy may cause long-lasting damage to job creation and businesses that can’t be unwound in a few months; that’s why it’s essential to contain the virus spread with effective measures, but we can’t forget that each month of lockdown means millions of unemployed and thousands of business closures.

The best course of action to tackle the health crisis, as well as the economic collapse risk, is to follow the South Korea and Singapore strategy, which is to implement strict prevention and testing measures, preserve the business fabric, provide safety equipment and health protocols for businesses to survive, and ensure that the economy continues to work while controlling the health crisis.

We can’t forget the difficult time that millions of workers and thousands of businesses are going through, and that’s why it’s imperative for governments to preserve the business fabric to avoid an economic depression of long-lasting social consequences.

The United States can recover the recent dramatic jobless figures in a few months if the government tackles the health crisis effectively and prevents an economic depression.

Health and jobs are not mutually exclusive. The United States will recover faster and stronger if the government puts both as the main objectives of policy.