A guest post by Arash Molavi Vasséi
This post summarizes a short policy note in which I argue that the only feasible as well as incentive-compatible solution to the current sovereign debt crisis in the Eurozone involves the European Central Bank (ECB)
- as a Lender of Last Resort to the Eurozone’s core countries like France, Austria, Finland, and The Netherlands, and
- as the Owner of Last Resort to the European banking system, thereby setting the stage for haircuts on the debt of potentially insolvent peripheral Member States like Greece, Italy, Spain, and Portugal.
The arguments for a credible commitment of the ECB to an unlimited swap line, promising to swap central bank liabilities for sovereign bonds with the aim to reduce liquidity premia, are well-known. So I won’t repeat them here. I will rather focus on the second part of my argument, on the ECB as an Owner of Last Resort. As far as I am aware of, the idea is new. I guess the idea is fundamentally flawed in a way that I cannot see. To cite Kantoos: “do poke holes into this proposal, as I am really interested in whether it could work”. Note, however, that I am full aware that the implementation of the idea is neither politically feasible, not is it legal (see the conclusion). My arguments are just concerned with economic admissibility.
The ECB as Owner of Last Resort
There are few economist who would deny that a haircut on sovereign debt is an incentive-compatible solution; the extremely serious downside is the risk of a breakdown of the European banking sector and global contagion.
But it seems possible to contain the risk of bankruptcy and contagion. In a first step, the European Banking Authority (EBA) should come up with serious stress tests, that is, with projections free of any political considerations, predicting the impact of realistic haircuts on peripheral sovereign debt as well as the impact of a Europe-wide recession on each Systemically Important Financial Institution (SIFI) in Europe. The most recent stress test may give a picture of the minimum level of recapitalization needs (114.7 billion overall; I expect a multiple). Next, the ECB should step in as the Owner of Last Resort and recapitalize each such SIFI according to the EBA’s projections. In contrast to its role as Lender of Last Resort, the ECB would swap central bank liabilities for preferred stocks, i.e., senior equity securities that carry no voting rights and, thus, prohibits the ECB from getting involved in the SIFI’s business models.
There are clear advantages of the ECB engaging as the Owner of Last Resort:
1. The most important reason why the ECB should engage in the recapitalization of the European banking sector is the same as usual: it can create unlimited amounts of central bank liabilities and, thus, unlimited amounts of premium-quality capital. The ECB as an Owner of Last Resort thereby avoids the vicious circle that any other realistic recapitaliization scheme would trigger: if Member States like France and Germany are supposed to finance heavy haircuts on peripheral sovereign debt, their own solvency could be endangered, respectively; this would suggest even higher default probabilities and potentially higher haircuts on sovereign debt. In turn, Member States would have to get involved in a second recapitalization-scheme, which would endanger their solvency and credit ratings even further; the feedback loop would continue until the entire Eurozone eventually collapses.
The same is true for any other limited fund like the EFSF, which is eventually backed by France and Germany (IMF-financed recapitalization would in addition endanger U.S. ratings; neither the Obama administration, nor the Republican presidential candidates show any interest in increasing IMF-funds; also China refuses to support the EFSF). By contrast, the ECB cannot become insolvent. That such a situation is considered in its constitutions is only due to the fact that it is designed by lawyers, obviously unaware of the basics of central banking: what makes a central bank so special is that the unit of account in a at system is defined in terms of its liabilities, and that its liabilities are used to redeem contracts. The monopoly producer of the means of final settlement just cannot get bankrupt, for bankruptcy happens if you lack the means to settle your obligations. Unconstrained by its constitution, any central bank can shield its equity capital against losses. All it needs to do is some creative accounting: it could invent an asset class, call them “claims to Europe’s future”, and neutralize any risk to its balance sheet.
2. The approach is incentive-compatible: it rescues banks, but punishes their owners. Given the increased quantity of SIFI-stocks, the share of profits generated by such financial entities that could be distributed to the private sector diminishes. In short, recapitalization is a blow to the return on capital invested, reducing the value of each stock in circulation as well as the value of newly issued stocks. This is why banks hate it, and why they negotiate insufficient haircuts. Thus, recapitalization by the ECB must be mandatory to avoid resistance by the SIFI’s managements – who are obliged by law to protect the interests of private shareholders.
3. The approach avoids deleveraging processes that otherwise will accompany the revision of the the EU’s Capital Requirement Directive (CRD IV), which implements Basel III (in fact, CRD IV goes beyond Basel III). By selling risky assets (like peripheral sovereign bonds) and cutting well-established credit lines to potentially profitable companies, banks increase their capital ratio, respectively, by reducing the denominator. By contrast, the ECB as Owner of Last Resort would increase the numerator, leaving no rationale to deleverage. This ensures that (1) bank lending to the so-called “real economy“ and (2) the transmission mechanisms of monetary policy remain intact.
4. Finally, and closely related to point 3, the ECB as Owner of Last Resort would back the possibility to implement significantly higher capital requirement over a horizon of ten to fifteen years. Research shows that high capital requirements are not detrimental to economic growth (Admati et al.). Instead, they ensure that systemically relevant institutions climb down the “Efficient Frontier“ such that a lower return on capital invested is compensated by reduced risk.
Ask yourself: Of all possible investments possibilities, why should systemically relevant institutions be the hotbed of relatively less risk averse or even risk-loving investors? All it needs is that the ECB injects more capital than projected by the EBA such as to ensure capital ratios around twenty or even thirty percent. In the aftermath of the crisis, the ECB would sell its preferred stocks during a period of ten to fifteen years, while commercial banks are prohibited to buy back these papers.
Liquidity distress – also due to policy uncertainty – seems to be an appropriate explanation of the spreads on the debt of the Eurozone’s core (see the paper for more). To contain the crisis, the ECB should act as a Lender of Last Resort, that is, it should credibly commit itself to an unlimited swap line as described above. However, to resolve the crisis the ECB should also act as an Owner of Last Resort with respect to the European banking sector and, thereby, set the stage for haircuts on the debt of potentially insolvent peripheral members of the Eurozone.
Of course, there is little hope that Germany will ever support such unconventional measures. It already brought France and Italy into line: they all announced not to seek for ECB intervention to rescue the Eurozone from a deepening sovereign debt crisis. But the problems with my proposal root deeper: it seems not only politically infeasible, but is clearly illegal. As an adherent to the rule of Law, I feel highly uncomfortable with my own suggestions. Yet, I am not aware of an economically admissible solution to the sovereign debt crisis in the Eurozone that also conforms to law, including those measures am opposed to. Given that the current legal framework does not support any feasible solution, and given that we do not have the time to adjust the legal framework, we will break the law anyway. Actually, we broke it already.
So this may be the major lesson of the political project to impose a common currency on a non-optimal currency area: any attempt to implement a political vision in contradiction to economic regularities (some may say in contradiction to „economics laws“) is not only doomed to fail, but also undermines the fundamental ingredient to a free and prosperous society: the Rule of Law.