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Part II – The costs of bailing out European banks

Many banks in Europe face insolvency. If we want to recapitalize them, this will likely cost us more than 5% of GDP – and there are even worse side effects of another round of bank bailouts.

 

Bailout is originally a maritime term that means removing water from a sinking ship. And as with today’s banking system, a bailout sometimes is not enough to make a vessel float again. (Photo: dimitrisvetsikas1969)

 

Bailout season has started. In contrast to 2008, the current crisis started in the real economic sector. But in a few months, the real losses in the economy will result in credit impairments for the European banks and eat into their ridiculously low capital reserves. It is only a matter of time until politicians and bankers once again tell us: Bail out banks, or all hell will break loose – in fact, the European Central Bank is supposed to already set up bad banks.

 

Before we decide on bailing out banks, however, we should answer the following three key questions:

 

  • What is the point of bailing out European banks?
  • How much does it cost?
  • Do the benefits justify bank bailouts?

 

Note that this article is part of a blog series on how the coronavirus pandemic impacts global finance. In a prologue, we have discussed what bailouts are and how they differ from other forms of government support. If you are new to these topics, we recommend you to read the prologue before continuing here.

 

Already through? Great, so let’s start.

 

Why should we bail out banks?

 

The obvious answer is: We all need financial services. We need payment services, savings advice, and access to credit to operate our decentralized and capital intensive economy. It is banks that currently supply all these financial services. Therefore, so the argument goes, we should bail them out.

 

This argument is flawed.

 

Banking and financial services are not the same. Although banks still dominate our financial system, they are not needed to provide essential financial services.

 

For example, bond and stock markets have never required the intermediation of banks. They have been around for centuries and were always important financial channels for companies and households. The same is true for collective investment schemes like mutual funds.

 

In addition, the past decade saw rapid progress in financial technology, or fintech. This has democratized the non-banking financial services once available only to big corporates: Fintech companies are connecting smaller companies and households directly to financial markets and with each other. Furthermore, peer-to-peer technology is also disrupting investment management and payments services.

 

With the technological capabilities of the digital age, finance no longer needs banking. The digital revolution is a game changer for the organization of our financial system, which is what we have described in detail in The End of Banking.

 

Back in 2014, this view was contrarian. But the rapid pace of technological progress in finance has turned it mainstream. Three years later, Christine Lagarde noticed in a speech at the Bank of England that new models of finance are replacing the old banking business. Today, even the banks no longer like to call themselves banks anymore, and the former governer of the central bank of Spain says farewell to the banks.

 

Clearly, we do not have to bail out banks because we need their services. Could we, however, have other reasons to bail out banks? Yes and no – well, it’s complicated.

 

Banking is not just a business activity. Over the 20th century, we have built our entire global financial system around banks. Banks not only provide financial services, but also create most of the money that makes our world go round.

 

Wait a minute: banks create money? Yes they do. For those of you who would like to know more how this works, our book The End of Banking gives a thorough overview; it also explains how digitization has fundamentally transformed this money creation process. For a quick introduction to the topic, we can recommend the walkthrough provided by the Bank of England.

 

So for the moment, let us not dive into this money creation, but discuss an important feature of this fact: By creating money, banking institutions create systemic risks. They borrow huge amounts from households and companies on short-term and, at the same time, lend to companies and households on long-term.

 

Banks operate large, leveraged, and highly connected balance sheets.

 

You can think of a large bank as a big domino stone right at the center of our economy. Its failure will trigger the failure of many households and companies that are linked to this bank. This likely triggers a chain reaction which will cause more banks to collapse, leading to a system wide crisis – hence the term systemic risk.

 

Falling banking institutions wreak havoc to the economy. It is because of this, and not because of their services, that governments have bailed out banks ever since. The classic textbook functions of banking are all replaceable by other financial institutions. The only argument for bailing out banks is that we fear the consequences of their failure.

 

There are high direct costs…

 

We used three different methods to calculate the costs of bailing out banks in Europe: Historical evidence, stress test results, and current balance sheet sizes. Let us go through each to estimate the price tag.

 

To start with the historical approach, we do not have to go back too far in time. Europe rescued its banks only a few years ago, after the Financial Crisis of 2007-08. The European Central Bank (ECB) has estimated that the size of those financial assistance measures was 5.1% of the eurozone GDP, of which 1.7% have already been determined to be lump-sum transfers that will never be recovered – for some countries like Ireland, the costs were way higher and the bill continues to rise.

 

Now, given this historical estimate, how much money would we need today to fund another bank round of bank bailouts? This calculation is simple: 1.7% to 5.1% of GDP translates into € 200 bn to 600 bn, or roughly € 600 to € 1’800 for every citizen in the eurozone.

 

Having calculated this first historical estimate, let us move on to the next cost measure: The stress tests conducted by the European Banking authority (EBA). The scenario exercise conducted by the banks in coordination with the regulator gives us an indication on how much bank equity might evaporate as a result of the Covid-19 pandemic.

 

For the adverse scenario, the EBA modelled an economic recession with eurozone real GDP contracting by 3% and average unemployment increasing to 10.3%. For this scenario, banks estimated an aggregate loss of € 226 bn – much lower than the historical estimate suggests.

 

With its scenario parameters, however, the EBA only tested for a mild recession – we have pointed that out already in an earlier blog post. Current estimates for the extent of the coming recession from the European commission and the European Central Bank range from a GDP contraction of 7.7% to 15%.

 

So the economic damage could be two to five times higher than anticipated in the EBA stress test. Using a linear extraploation of the stress test results, losses in the banking sector could pile up to more than € 1 tr. Shareholders and subordinated creditors may absorb a part, but taxpayers would still have to inject several hundred billion euros to stabilize failing banks. If we assume that banks have 2% of the total balance sheet as equity buffer, the size of bailouts would range between € 100 bn and € 650 bn.

 

So far, the two different approaches came up with rather similar results. As mentioned, there is yet another way to estimate bailout costs: Taking the size of banks’ balance sheets and calculating the costs for each percentage point of losses on the assets. The reasoning behind is that these losses will eventually eat into the bank’s equity buffers. Once those have eroded, taxpayers would have to jump in and recapitalize the banks.

 

Total assets of the eurozone banking sector amounts to € 24 tr per end of December 2018 according to the latest data from the ECB. There is, however, also the part of the financial system that is commonly labled “shadow banking”. The European Systemic Risk Board estimates the size of this sector to account for another € 33 tr. These are impressive figures. The balance sheet size of the banking and the shadow banking institutions in the eurozone is almost five times its GDP.

 

Some parts of the European Shadow Banking sector performs the same functions as the traditional banking sector. Hence, this sector might also need taxpayer support to prevent systemic risks from unfolding in the financial system. Having said this, however, the European shadow banking is less researched and understood than the shadow banking systems from China and the U.S. It is hard to predict today what fraction of the European shadow banking sector needs a bailout too.

 

This uncertainty forces us to make some assumptions. Let us assume that all investment funds other than money market funds will not have to be backstopped, while everything else has to. This amounts to 66% of the European shadow banking sector that needs to be bailed out in a crisis.

 

With this assumption, every percentage point of equity that must be replaced would cost roughly € 460 bn. So if banking institutions inflict a loss of roughly 5% on their assets and they have 2% of equity buffer, taxpayers would have to inject about € 1’400 bn – this is about 12% of eurozone GDP or almost € 4’000 per citizen.

 

Enlarge graph by clicking on it. The uncertainty around the price tag is high, but one thing is certain. It will be expensive (Source: see text)

 

So if we take the shadow banking sector into consideration, the funds needed to rescue failing financial institutions are much higher. Only looking at the traditional banking sector, the numbers are remarkably similar nonetheless which approach is taken. Of course, all three methodologies applied to calculate the costs of bank bailouts are simplistic. Yet the dimension of the funds needed is gigantic. Another round of bank bailouts will cost Europe dearly. Every citizen of the eurozone – every newborn, teenager and adult – might need to put up more than € 1’000 on the table to keep traditional banks afloat, if we have to rescue the shadow banking sector, too, this number will be much higher.

 

… and even higher indirect costs

 

Besides the staggering direct costs, a bailout will also result in high indirect costs. We have described these negative effects in our previous post, and they are equally – if not more – worrying than the direct costs: Bailouts lead to cronyism, reward irresponsible behavior, and lead to an inefficient allocation of resources in the economy. We can see all of these effects already today, as Europe bailed out countless banks since 2008 and thereby established a full-insurance culture.

 

Let’s take cronyism and irresponsible behavior, for example. Since 2008, bank managers and shareholders know that they get rescued without any questions asked if things turn out bad. As a result, they have started to erode the financial buffers of their companies by paying themselves bonuses and disburse dividends.

 

We digged into the financial statements of the global systemically important banks (G-SIBs) in the eurozone that are traded on the stock market. Doing so, we learn that these seven banks distributed more than € 70 bn of dividends and bonuses between 2015 and 2018 alone (see the illustration below).

 

Enlarge graph by clicking on it. In only four years, these large European banks distributed more than € 70 bn to their sharholders and employees. (Source: Financial reports of the respective banks)

 

Deutsche Bank, a particularly unprofitable bank that has virtually no equity in reserve (see our previous post here), disbursed in just four years almost its entire market capitalization to employees and shareholders. No company that cannot count on taxpayers’ money in times of crisis would do this. It is past bailouts that motivate such a behaviour unseen in “normal” companies, as no sane enterpreneur would operate with so little financial leeway, as he or she would always be at risk of becoming bankrupt.

 

One thing is sure: If we bail out banks again, this behavior will get worse. And if we bail out institutions in the shadow banking sector, too, this behavior will get more spread out. This will both increase the likelihood and the severity of another crisis.

 

We pay a heavy price for bailing out banks. Consequently, the benefits would need to be enormous to make bailouts still worthwhile.

 

Do the benefits justify bank bailouts nevertheless?

 

Some economists argue that only bank bailouts can prevent a deep recession.They regard bank bailouts as strong medicine: it tastes ugly and has serious side effects, but it will heal our economic woes and will enable a swift recovery. That is why we should go for it.

 

We have heard the same argument last time around. And as we all know today, it did not turn out that way. When Europe rescued its dysfunctional banking sector after 2008, it experienced a lost decade, a slowdown in productivity growth and ongoing high unemployment.

 

Not even for the banks themselves it seemed to have worked out. Last year, The Economist noted that European banks “are stumbling around in a fog of bad performance, defeatism and complacency.”  

 

Hoping that these weak institutions might drive a swift and sustainable recovery seems like utter madness. Even if they get another injection of taxpayers’ money, these zombie banks will keep on surpressing productivity growth and preventing the re-allocation of capital into growth sectors – just as researchers at the ECB have recently stated in a working paper. 

 

So instead of ensuring a V-shaped recovery, bank bailouts will prevent it. If politicians and regulators repeat the mistake from 2008, they will extend the lost decade of Europe into perpetuity.

 

We will have heavily indebted governments and zombie banks. Both will barely manage to keep each other afloat by ever increasing amounts of debt while the continent sleepwalks into a persistent economic depression.

 

This leads us to the final price Europe is going to pay for bailing out its banking sector again: political disintegration. Bank bailouts are so expensive that countries like Spain or Italy will be unable to afford it without help from Germany or the Netherlands.

 

Bailing out the European banking sector will require some form of debt mutualisation. But rescuing failing dysfunctional banks is a particularly bad justification to deepen the political union; it will barely inspire European solidarity. More likely, the financial burden of bank bailouts will strengthen nationalism and eventually undermine Europan unity.

 

Bailing out banks is a terrible idea!

 

So what should we do instead? In the next post of this blog series, we will present an alternative to bank bailouts. Stay tuned.

 

 

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Blog series
The Coronavirus pandemic and its impact on global finance

 

This blog post is part II of a series of articles that we are publishin over the coming months. We think that the Coronavirus pandemic will have a thorough impact on the global financial architecture. With our analysis, we want to shed light on how the banking systems in Europe, the US, and China might be affected, and what the impact on the global monetary system could be.

 

Prologue
Economics in the time of Corona
April 17, 2020

 

Part I
The upcoming banking crisis in Europe
March 27, 2020

 

Part II
Bailing out European banks is not the answer
June 10, 2020

 

Part III
How bank regulators and the European Central Bank should prepare
To be published later

 

Part IV
The Golden Age of banking in the United States
To be published later

 

 

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