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Yesterday I was on BBC World News talking about what I am provisionally calling the European Bank Bailout. The topics were the US dollar liquidity for European banks and the trading losses at UBS. It was interesting that the BBC put these two together, because I think they are inter-related. What I ended up saying on air was that the two bits of news highlighted three specific problem areas in today’s global financial system.

  1. The structural deficiencies of the eurozone have led to a panic that is similar to the liquidity crisis we witnessed after the subprime meltdown in the US, creating funding difficulties for European financial institutions.
  2. European banks are particularly undercapitalised. It is worries about the solvency of these banks in the event of a sovereign debt default in the eurozone, which has created what should be considered a bank run via the wholesale funding markets.
  3. Banks are engaged in risky activity which makes their undercapitalisation that much more worrisome. The losses at UBS underscore this last point.

I have written about the eurozone issue ad nauseam. So I will just highlight what I wrote previously. (See “Did joining the eurozone bust Ireland?” from 2008, “Spain is the perfect example of a country that never should have joined the euro zone” from 2010 and yesterday’s post on Greece, “German economist: 'There is no alternative but Greece's euro zone expulsion.'”) The bottom line is that quick fixes like liquidity from central banks are merely a stop gap. The euro zone has serious structural flaws, some of which can never be remedied, but merely tolerated.

But on the banking issues, I think the problem is mostly about regulation. Too-big-to-fail financial institutions are engaged in risky trading activities that blew up the global economy once already. Here again, those same institutions are threatening to create a meltdown, this time because of their inadequate funding. If we want to prevent crises, we have to deal with this in fundamental ways instead of just bailing these banks out by having central banks provide cheap funding.

Here’s the problem with the present solution, as I put it about the Fed’s role during the first panic:

The Fed has been hugely politicized and this is going to be a problem for some time to come. With the Fed still acting as a quasi-fiscal agent through its backdoor recapitalization of the banks, you can bet calls for more oversight will continue. --The political central bank, Jan 2010

Three articles I read get to the problems with these liquidity bailout:

First comes from the US, where Warren Mosler asks why is the Fed lending dollars unsecured to the ECB... again? He says “Congress should not allow the Fed to lend unsecured to foreign central banks without specific Congressional approval” because “It’s like lending your dollars to someone in a far away land who uses his watch for collateral. But he gets to keep wearing the watch, and he’s out of your legal jurisdiction.”

Second is the Anne Sibert article on the damaged ECB legitimacy. She writes that the ECB has been opaque about how it conducts monetary policy, as well as how it provides liquidity. It is the second part that worries her most, because “In its attempt to maintain financial stability the ECB and Eurosystem have had to walk a fine line between providing just enough liquidity to keep potentially solvent institutions afloat and subsidising the financial sector.” Does that sound familiar? It should, because the Fed operated in the same opaque manner during the first crisis.

Finally, there is growing evidence that ECB Chief Economist Juergen Stark quit his job because “he did not want to support the lending of dollars to euro-area banks.” Former Bank of England central banker David Blanchflower told Bloomberg News this in a radio interview yesterday. While Blanchflower says this was much needed and “should have happened a while ago,” it puts the central bank in a quasi-fiscal role that had already caused another high profile German, Axel Weber (widely tipped to have been in line for the top job) to resign from the ECB as well.

The common thread in these three articles is how central banks are taking on quasi-fiscal roles because the fiscal agent is lacking as in Europe or is unwilling to take bold steps toward a permanent solution to a systemic problem. I am going to leave it there for now, since this post is getting a bit long. I know I haven’t addressed solving the problem, but that’s a whole post in and of itself. I think the issue is bank regulation and these regulatory fixes can also solve the rogue trader problem. What we need is ring fencing of core deposit-taking activities, much greater capital ratios and more diligent oversight. Until we get cracking on these issues, crises will continue to plague the financial system. And that means massive central bank liquidity at subsidised rates and bailouts.

Source: Central Banks Step In As The ECB Flounders On Fiscal Policy