It seems like a war among economists has started. First, around 170 German/Austrian economists rallyied around Prof. Hans-Werner Sinn in an open letter predicting no less than the expropriation of German savings. Then a group around Prof. Peter Bofinger published its rebuttal and called Prof. Sinn “irresponsible”. And now a group of eonomists including the highly respected Beatrice Weder di Mauro (former member of the 5-person Council of Eonomic Experts) published a Manifesto for a European Banking Union
What is this fuss all about? It’s about the notion that a European banking supervision, a European deposit insurance and a European bail-out fund for banks would restore confidence in the Eurozone. The idea is “to de-couple banks and states”.
The idea that one can decouple banks and sovereign states in the EU through new institutions is a fairy tale. It is not a fairy tale in the US, but not only because the US has centralized bank supervision and a central Treasury.
Whenever the State of California goes bankrupt, the Californian Wells Fargo Bank (as well as other Californian banks) remains possibly untroubled by this. Why? Because the Wells Fargo Bank’s creditworthiness can be determined on its own merits. If the bank’s loan portfolio is first class; if their risk management of trading activities is convincing; and if the bank makes a decent profit — well, then very few people will care about the fact that the Wells Fargo Bank is located in a state which is bankrupt.
If, however, the Wells Fargo Bank had invested about one-third of its assets in Californian bonds and if the State of California could unilaterally decide to give up the USD as the currency and create new Flower Money — well, then Californian banks would face a run as soon as their state goes bankrupt (probably way before then). And no Banking Union could stop that run. On the contrary, banks outside California might end up in trouble, too.
The greatest flaw is not the design of the monetary union but, instead, the Basel-II regulation that government bonds are considered risk free, that they are not included in the calculation of leverage and that they do not need to be reserved against. No financial investment in the world is risk free; why would government bonds be?
This faulty Basel-II regulation prompted banks to run up “real” leverages to levels which the world has never seen: Deutsche Bank’s leverage is almost 40 to 1! In comparison, JP Morgan and Citigroup show leverages of around 10 to 1. Leverages at 20 to 1 or above have typically been reserved for hedge funds. From the standpoint of leverage, Deutsche Bank (and other large European banks) are more like hedge funds than like commercial banks. Even with a European banking supervision, Deutsche Bank will remain “coupled” with, say, Spain as long as it has huge amounts of Spanish bonds on its books.
What is the solution to restoring confidence in financial markets? One has to take all assets of questionable value (i. e. troubled government bonds) off the books of the banks and, going forward, one has to limit the amount of such bonds which banks can hold (establish risk provisions for them, too). Only when bank balance sheets reflect realistic asset values will confidence return to markets again.