Time for Europe to embrace monetary change

The ECB in Frankfurt
needs to be less German

These past few weeks history has been written regarding bank regulation, bank supervision and monetary policy.

The events in Cyprus has delivered the following lessons that are being noted, considered and will have to be adopted:

1. Banking is a risky business and therefore licensed banks need better capital ratios.   Steps in this direction have already been decided through Basel III and the EU Capital Requirements Directive IV.  But bank capital alone is not enough.  Other capital buffers are needed.
2. Banks should not rely exclusively on deposits for their funding.   They should move part of such deposits to provide the required capital buffers in the form of senior and subordinated bonds that are not insured and that can be converted into equity in case of crisis so that the taxpayer is never again put on the hook to save banks in distress.
3. Regulation must provide for clear pecking order for the protection of liabilities on banks' balance sheet.  Maximum protection has to be given to insured deposits, uninsured deposits have to rank ahead of senior bonds and bonds than have to rank in line with the seniority or subordination level awarded to them.   Banks obviously have to pay a higher rate to liability holders as the risk increases so that uninsured deposits must henceforth attract better rates than insured deposits.
4. Europe must move faster to restore confidence in its banking systems to create a Banking Union and a Euro area wide Deposit Insurance Scheme.

On the front of monetary policy we have seen a Damascene conversion by the Bank of Japan (BoJ).  Following the change of government in Tokyo, BoJ has moved from a conservative to a vastly aggressive monetary policy.   Japan joins the US Federal Reserve and The Bank England in adopting aggressive monetary accommodation, technically known as Quantitative Easing  (QE).  This is basically artificial creation of money to make up for the fact that money is circulating much more slowly than before and banks are not lending money to expand the monetary base.

The Financial Times defined BoJ action as all but scattering cash from a truck which is a derivative to the symbol of throwing money from a helicopter associated with the Federal Reserve Chairman Ben Bernanke.

Can the Euro Area governments, especially Germany, continue  to deny the ECB from responding to Europe's economic crisis with similar QE and other monetary measures?     Can we be happy with saving countries from economic death through bailouts but keeping them eternally in the sick bay as we are not offering proper medicine to restore them to health?   Saving someone from death is not the same as making them healthy again.

I would argue that in the absence of the necessary structures to take common fiscal measures to stimulate pan-Euro area economic growth, Europe needs more monetary accommodation than other countries, not less.

If institutional arrangements deny the ECB a clear mandate to adopt monetary easing because the ECB is tasked only with an anti-inflation mandate and bears no responsibility for economic growth and other social objectives, then Europe must do something to understand that monetary policy cannot be divorced from other economic realities.      I would not interpret the ECB mandate so narrowly.   The ECB has responsibility for price stabilisation both to avoid inflation as much as to avoid a depression.  If inflation falls below the 2% target the ECB has already the mandate to adopt whatever measures are needed, including QE, to restore price stability.

The ECB should also be facilitated to depart from the 2% inflation target when other economic objectives are not being met.     Who would not prefer 3% inflation and unemployment at 5% rather than 2% inflation and 10% unemployment?    Who can put a price in political and monetary terms to the whole generation of young unemployed in Spain, Greece, Cyprus et al?   This represents utter waste of resources.

Restoring Euro countries in distress to sustainable economic health and growth is conditional on their banking system being sufficiently restructured and recapitalised so that their banks can start executing properly their function to transmit to the market the interest rate policy decisions taken by the ECB.   Reducing interest rates alone will not be enough firstly because interest rates are already low and a quarter percent here or there won't make a difference, and secondly because borrowers in countries in distress are having to pay much higher rates on their banking facilities, if they find such borrowing facilities at all.

The obsession to continue financing the recapitalisation of such banks through the fiscal account either of the sovereign concerned ( that would already be in distress and could thus be prejudicing its own sanity to save its banks) or through contributions or commitments by other sovereigns through the ESM must end.   The ESM can be given a banking licence and be fully monetised by the ECB to break the vicious link between the governments and the banks that is working to reciprocally pull down both below the water line.

Insolvent banks that have lost their capital and their deposits must be resolved with creditors suffering the consequences in line with a clear prioritisation mechanism where shareholders and subordinated debt holders get wiped out before senior debt is converted to equity and uninsured deposits be converted to blocked senior debt as necessary to avoid erosion of the deposit base.    But banks that are merely insufficiently capitalised must be capitalised by  ECB monetisation through the ESM to render them effective again and efficient in transmitting throughout the Euro area the monetary and interest rate decisions taken by the ECB council.

Otherwise what do we need an ECB for?  Who needs a fire engine without water in its bowser?

Finally a word for those who are still dreaming about  compensation for the former shareholders of the National Bank of Malta.   Cyprus has just provided the clearest living day example that when a bank is insolvent not only the shareholders get wiped out but if necessary all other creditors including uninsured deposits.    The National Bank in December 1973 was insolvent to the point that it had lost all its capital.   It was restructured and re-capitalised and brought back to health under a new legal structure through Bank of Valletta.   Depositors were spared.   Shareholders are risk takers, they take the plum when the going is good they lose it all when their management they appoint misbehaves.  Period.