Saturday, March 28, 2009

Monetary union and banks - some thoughts

The biggest – and most consistent criticism that my last post received is that the national champions in Europe (particularly the Netherlands) are in deep trouble.

I was very careful describing how HSBC Hong Kong should be capitalised (separately and with very large – even 100% - capital charges for cross border funding).  If this had been done in the Netherlands there would be no trouble.  Even the Icelandic banks would have survived in Iceland - though their UK subsidiaries would be worm food.

The problem is that cross border funding by leveraged institutions is dangerous.  It almost caused Citibank to fail in the early 1990s.  It was a key part of the bank collapse in Korea.  In this cycle it was key in the Dutch banks, in Sweden as I wrote about here.  It was also key in Norway and Sweden during their famous bank collapse (here).

Monetary union and currency zones are famously dangerous for banks.  

But more to the point - banks intermediate current account deficits - and that can make country problems contagious.  

This leads to a question on which I express only a weak view.  In some sense the issue in America this time is also monetary union.  Because of the peg there is a sort of monetary union between China and the United States.  It was the supply of Chinese savings that – as much as anything – powered this boom. 

My question?  Is there a safe way of recycling all of those offshore dollars held in China and oil exporting countries?  If there is not then the value of having the reserve currency is massively overstated.



Advant Guard said...

Having a reserve currency has benefits and drawbacks. The benefit is that your interest rates are lower. Other countries are subsidizing your borrowing as part of the cost of insuring against a currency crisis. But you also have slower job growth and larger current account deficits because other countries are so eager to accumulate your currency.

It takes a certain amount of political will to maintain a reserve currency because there will always be those who resent the job losses. That is why the Euro will never become a major reserve currency. Without running persistent current account deficits, there will never be enough Euros available to provide the kind of liquid and deep market that is desirable in the reserve currency.

Anonymous said...

JH, you might want to ask brad setser this question

Anonymous said...

The Irish banks are national champions in the manner you describe, normally have been very profitable and were not brought down by foreign lending, but by domestic lending.

The biggest bank, AIB, was bailed out only 25 years ago after it bought an insurance company and nearly had to be bailed out a few years ago when a single trader (John Rusniak) lost US 650M on the forex market.

And that last example shows another way your proposal may not work. A single trader like a Rusniak, Leeson or Jerome Kerviel can bring down even the largest bank. And regulation won't necessarily work because all of these traders were supposedly working in low risk. If the bank's internal controls failed to flag these traders as high risk, what chance an external regulator.

John Hempton said...

I was wondering when someone would bring up Ireland.

Had the Irish banks had to separately capitalise their offshore operations then they would still be here today. The offshore operations would be gone.

Sure the holding co might die - but the Irish regulated subsidiary would live on and would cost the Irish taxpayer zip.

I am careful about requesting separate capitalisation. Branch banking is DANGEROUS.

Anonymous said...

Not sure I agree with your conclusion on Ireland. The bank's were overexposed to the Irish property/construction market. When that bubble collapsed, they went down. It had nothing to do with their non-Irish operations. Rusniak was years ago and Anglo/Allied's/BoI's UK operations are bringing in large amounts of liquidity at little risk (except for the UK depositors which are now taking Irish state risk - yikes).

Still, there is an exception to every rule and you've won me over on your general argument. In fact, just reading the Economist who reports on reasons for the recent failure of UK building societies which should have been safe. An abstract:

"But there is a broader issue. Since the onset of the credit crunch, many have mused on the attractions of narrow banks, limited in their operations and regulated almost like utilities. Building societies are not a million miles from this model. Yet in the past four months, six of the 59 that existed a year ago have been pushed into rescue mergers."

I still think this is better than the majority of UK banks that have gone down but back to the article.

"What caused this veering towards risk, says a former Dunfermline director, was ferocious competition in mortgage lending from banks and the specialist lenders that sprang up in the 1990s. Building societies, obliged to put 75% of their lending into residential mortgages, found profits (which they needed to bolster their capital) shrinking. "What do you do when your core product has become everyone else's loss-leader?" says the ex-director."

This very much supports your core position. However, what do you do about those annoying competitors - specialist lenders like GMAC? The answer in the short term is since the securitization market is dead, their business model is likewise dead. But in the longer term I can see a revival in securitization with higher quality loans, better credit ratings, etc. This may be 5 years out but it will happen. Do you regulate this competition out of business?

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