Mario Draghi, European Central Bank president, has reduced the risk of a eurozone break-up by undertaking to buy unlimited amounts of sovereign bonds in the secondary market. ECB purchases will require deep budgetary and economic reforms by participating nations. Angela Merkel, German chancellor, is right to insist on these reforms over time. But a genuine solution to the crisis also requires shoring up Europe’s banking system to restore the flow of credit to businesses and households.
Europe must ultimately grow its way out of its crisis. Economies cannot grow unless banks have sufficient capital to lend and businesses have the confidence to borrow to expand their operations. As was the case in the US in 2008 and 2009, central bank intervention cannot succeed on its own. Then, actions by the US Federal Reserve were bold, creative and necessary to help put a floor beneath a crumbling credit system. However, the Fed was limited in what it could achieve on its own. In the US, the end of the banking crisis required private capital investment, encouraged by incentives and financial commitments from the government. The same must happen in Europe.
Now is the time to rebuild confidence in Europe’s weakened banks through an accelerated introduction of robust, credible capital standards and the injection of new private capital. Banks will begin to lend only when they have sufficient capital and liquidity. The conventional wisdom that more robust capital standards constrain lending is borne out by neither economic theory nor the facts. In the US, where the largest banks were compelled to raise capital in 2009, business loans at commercial banks have increased significantly since.
The Basel III global regulatory framework will require banks to meet enhanced capital adequacy standards gradually by 2019. Europe cannot wait that long. Waiting seven years to address the banking system’s weaknesses runs the risk of seven more years of weak growth.
We propose that the biggest eurozone banks should be required to meet Basel III capital standards by the end of 2013, following a rigorous and credible validation of their balance sheets. To ensure credibility, the ECB should lead this validation. Banks should be required to increase their capital ratios primarily by increasing equity – not by reducing credit and so deepening the crisis.
While this validation process is under way, the eurozone must act to limit market uncertainty about the ultimate fate of its most significant banks. Governments can do this by committing to provide public capital to the extent that these banks are deemed to need additional financing and are unable to raise private capital to meet the new standards. Such an approach worked in the US.
In 2009, the US government assessed the balance sheets of the nation’s 19 largest banks and set robust capital requirements for each. The US Treasury pledged that any bank that did not raise sufficient private capital would instead receive the capital via investments by the US government. Each bank was able to meet the new standards entirely from private sources. This marked the beginning of the end of the US banking crisis.
By pledging to purchase equity in their major banks at a price based on a discount to today’s market, eurozone governments would set a floor under the capital raise. This would give private investors the confidence to invest. Setting this floor at a significant discount to market prices would be fair to taxpayers and provide strong incentives for the banks to achieve the required capital levels through the markets rather than relying on government infusions. To the extent that an individual country is unable to provide a credible backstop, it would be extended through the European Stability Mechanism.
Any ECB bond purchase programme for a specific country would also be contingent on that country committing to the bank recapitalisation plan. To attract private capital, a consolidation of the banking sector will probably have to occur in those markets that have too many unviable banks.
What we propose does not address all the economic challenges facing the eurozone. These challenges are complex and require political will, policy solutions and institutional changes. Ultimately, the eurozone crisis is not one but two crises: a sovereign debt crisis and a banking crisis. Because they are intertwined, they cannot be fully resolved without action on both fronts. That is why, alongside fiscal consolidation and economic reform, Europe must restore confidence in a healthy banking system that can serve its critical function of supporting growth on the long road to recovery.
The writers are respectively former chairman of the Swiss National Bank and a fellow at Oxford’s Blavatnik School of Government; and CEO of Alliance Partners and former counsellor to the US Treasury secretary
Get alerts on European banks when a new story is published