Why bank regulators fail?
Killing off some zombie banks would be good for a system where banks are hoarding capital rather than lending it, but there is little political or economic incentive to do so
Pity the poor regulator, in this case a banking regulator. The European Union has just appointed Danièle Nouy as head of the new European Central Bank (ECB) Single Supervisory Mechanism (SSM). The SSM is to provide the entire Eurozone with a central regulator. It will directly supervise the 30 or so leading Eurozone banks. It also has the power to overrule national regulators and intervene in operation of the Eurozone’s 6,000 smaller banks.
Ms Nouy has vowed to be tough. She has warned that some of the region’s lenders have no future and should be allowed to die. But she has a major problem. She is up against intense economic and political incentives to keep the real level of bad loans quiet and the banks in existence. She is also not alone. These incentives exist everywhere. Bankers don’t want to admit to a weak balance sheet. Company managers don’t want to lose their firms and jobs. Politicians want the economy to appear healthy.
Carinthia is the southernmost Austrian state or Land. It borders Italy and Slovenia. It is within the Eastern Alps. With its picturesque mountains and lakes, it could be almost perfect, except for one thing. It owes about €14 billion. Its situation can be traced to its relationship to Hypo Bank, a former subsidiary of the German Bank Bayern LB. Hypo was taken over by the Austrian government in 2009. The government decided not to let it fail, because if it did, the guarantees given by Carinthia would become due. So Hypo still has bad loans of €18 billion on its books. No doubt the SSM would love to let it fail, but the Austrian government won’t allow it.
Italy is in the same situation. It does not want to shut down any bank. It would draw attention to the rising levels of nonperforming loans and put the country’s credit rating at risk. It is a real problem because the gross nonperforming loans in Italy reached €150 billion last November and has been growing at 22% per year. Killing off some zombie banks would be good for a system where banks are hoarding capital rather than lending it, but there is little political or economic incentive to do so. With massive amounts of cheap money from the ECB, it is easier to extend and pretend. So in a way the easy money policies of one part of the ECB are making the job of its regulatory arm that much harder.
Just like its neighbours Austria and Italy, Slovenia has problems with its banks. Its banks are burdened with €7 billion in bad debts. This is a crushing debt load for a small country with a population of only 2 million. Still it insists that it does not need a bailout. To solve the problem, it will establish a “bad bank”. The bank will buy bad loans from the country’s banks in exchange for short term bonds, but there it ends. The central bank has said that it won’t hold the bad loans indefinitely. Instead it hopes to sell them when they are “interesting to the market”. You have to wonder that if they will ever be interesting to anyone.
Europe generally has far greater levels of rule of law and stronger institutions than emerging markets. Yet even there the EU federal regulators are having issues. Their colleagues in the developing world are up against much larger, but similar obstacles.
Any regulatory issues have been exacerbated by another common characteristic of emerging countries. They all have shared a colossal credit boom. Loans have been growing by double digits for many years. The loans will not all be paid back.
In both India and China, loans are made to individuals and firms whose strengths are their connections more than their balance sheets. Since state banks dominate in both countries, the best connections are to politicians, who have few incentives to help the regulators. Loans based on connections are often backed by guarantees rather than collateral. An effort to collect such loans would put not only the connected debtor out of business, but affect another prominent individual or more often a state-owned company.
A recent example occurred in China. The Credit Equals Gold No. 1 was a product created by China Credit Trust, one of the largest Chinese trust companies. These companies are part of the $1.2 trillion shadow banking industry. They are outside the normal channels of regulation. Unfortunately the money raised from investors of Credit Equals Gold was loaned money to Shanxi Zhenfu Energy Group, a coal company that went bankrupt.
Credit Equals Gold was distributed through the offices of the world’s largest bank, Industrial and Commercial Bank of China (ICBC). Investors thought that the product was backed by the bank and the trust company. It wasn’t. Although a tiny part of a huge industry, a default by an investment product could potentially have systemic and catastrophic consequences. So Credit Equals Gold was not allowed to go under. An unnamed group bailed out its investors. Regulators never had a chance.
India has similar problems. Total problem asset are estimated to be about 10%. The State Bank of India (SBI) has promised to go after reluctant borrowers, but like other Indian banks, it will have difficulty collecting. Like the Chinese banks, many loans in India are secured only with personal guarantees from the firm’s promoters. Loans were also given as the result of bribes to the loan officers or pressure from politicians. Corrupt bankers and politicians certainly do not want their dirty laundry dredged up in a messy collection process.
The real issue for regulators is as always information. How can Ms Nouy and the SSM decide which bank to shut down if no one wants to give her accurate, timely and complete information? The problem is many times worse in emerging markets. The sad part is that if the problems are identified in time, it might be possible to have an orderly liquidation and limit the damage to the worst case. In contrast nasty surprises, and there will be many, can cause a liquidity crisis. If the banking system freezes up, everything is at risk and nothing will be orderly.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)
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