Readers know that I am not a big fan of things European, putting it mildly.
Even so, it heartens me to note that the first sensible step by governments
against the excesses of the financial system was taken this week by the
unlikely figure of the European Union (EU) Commissioner for Competition, Neelie
The action that got my attention, and approval, was her ruling on the case of
government aid for the Dutch banking group, ING
Groep NV. As the Financial Times reported this week:
The dismantling of
ING is one of the toughest interventions yet by Europe's competition
authorities, which waved through state aid to financial groups during the
crisis but made clear these would be subject to scrutiny if they later appeared
ING must offload its insurance business, worth an estimated 12bn euros [US$17.8
billion] - 15bn euros, and focus solely on banking to meet the commission's
demands, a decision that goes substantially further than expected. The break-up
also includes a requirement that ING sell ING Direct USA, its US banking arm.
ING will be left with a balance sheet about 45 per cent smaller than before it
turned to the state last year, roughly equivalent to Commerzbank, the German
lender. (Financial Times, October 26.)
Stock markets did not
like the news, with the equity price of ING falling 22% from the morning of
Monday, October 26, to the end of Thursday, October 29, on the Amsterdam stock
exchange, with the low price on Tuesday recorded at 30% below. As the Financial
Times reported on Tuesday:
Shares in ING plunged 18 per cent yesterday
after the group surprised the market with a larger-than-expected cash call and
plans to sell off the group's insurance and investment management operations.
In compliance with the European Union's competition commission, the Dutch
financial group said it would raise 7.5bn euros (US$11.1bn) via a rights issue
to help repay Dutch state aid and fund repayment penalties for state guarantees
on risky assets.
The capital raising was 2bn euros higher than analysts at Keefe, Bruyette &
Woods had expected, and the brokerage said it had put ING's price target under
review. (Financial Times, October 27.)
There are multiple
approaches to the ING story; one can focus on the stock market reaction, and
independently also evaluate the scale and scope of the decision itself. Since I
have been writing about irrational stock market investors over the past few
months, it is probably appropriate to start with that point of view.
To wit, why did equity investors not like the news surrounding ING?
Based on media reports, it appears that the following were the primary factors
behind the "scalded cat" reaction:
1. The business restructuring plan that ING had to do was considered
much more punitive than equity holders had been expecting (hoping?) for. 2. Equity capital raising by ING was pegged sufficiently higher than the
market had initially expected, diluting current shareholders further. 3. Potential future growth opportunities embedded in the equity price
had diminished by the actions - for example the sale of investment management
may have reduced the opportunity to earn fees. 4. Left unsaid in all of the above, the idea that ING was "too big to
fail" had diminished considerably from the restructuring; that is, it had
effectively become more likely that the company would be "allowed" to fail in
the next crisis
There is first the matter of irrational investor expectations to consider. To
expect that a failing financial institution that had been rescued with taxpayer
money could get away with a low fine for its near-death experience suggests
very much that investors are in a different world - filled with amnesia, rather
than a belief in fundamentals. The strategy is otherwise known as a "get out of
jail" card, which is to suppose that the act of bailing out an institution
would create too many arguments against a future penalty.
That has now been set right. The other point to consider is that the "smaller"
ING is now not of systemic importance, effectively rendering the "too big to
fail" argument moot. Herein lays the route to the other part of the decision,
namely its wider implications for other banking groups.
Stock markets have been debating the effects of the outburst by Bank of England
governor, Mervyn King (which I highlighted in my previous article
The truth about banks and dogs", Asia Times Online, October 24, 2009),
when he echoed the comments made by the well-known business economist, John
Kay, on the subject of narrow banking: the fashion of separating the public
utility side of banking (retail deposits, check and draft facilities,
commercial lending, mortgages and so on) from the more risky "casino" type
activities (investment banking, proprietary trading and so on).
The notion behind narrow banking is to create a supervisory and regulatory
separation between activities that are in the public good, and those that
aren't. Following from the comments of King that elicited hostile reactions,
Kay wrote again on the subject this week:
It is impossible for
regulators to prevent business failure, and undesirable to pursue that
objective. The essential dynamic of the market economy is that good businesses
succeed and bad ones do not. There is a sense in which the bankruptcy of Lehman
was a triumph of capitalism, not a failure. It was badly run, it employed
greedy and overpaid individuals, and the services it provided were of marginal
social value at best. It took risks that did not come off and went bust. That
is how the market economy works.
The problem now is how to have greater stability while extricating ourselves
from the "too big to fail" commitment, and taking a realistic view of the
limits of regulation. "Too big to fail" exposes taxpayers to unlimited,
uncontrolled liabilities. The moral hazard problem is not just that risk-taking
within institutions that are too big to fail is encouraged but that private
risk-monitoring of those institutions is discouraged.
... Their activities underwritten by implicit and explicit government
guarantee, it is increasingly business as usual for conglomerate banks. The
politicians they lobby sound increasingly like their mouthpieces, espousing the
revisionist view that the crisis was caused by bad regulation. It was not: the
crisis was caused by greedy and inept bank executives who failed to control
activities they did not understand. While regulators may be at fault in not
having acted sufficiently vigorously, the claim that they caused the crisis is
as ludicrous as the claim that crime is caused by the indolence of the police.
The governor of the Bank of England is one of the few public officials to have
grasped that the primary purpose of regulation is to protect the public, both
as taxpayers and users of financial services, and not to promote the interests
of the financial services industry. When the next crisis hits, and it will,
that frustrated public is likely to turn, not just on politicians who have been
negligently lavish with public funds, or on bankers, but on the market system
In contrast to the lively debate being witnessed in the
United Kingdom (or at least in its leading financial newspaper), the United
States appears to be headed in precisely the opposite - and in my opinion wrong
To wit, the general consensus between the Federal Reserve and the US Treasury
appears to be that US banks should not face either punitive charges for
receiving capital guarantees, nor be forced to make amends by becoming smaller
in size. The Market Watch section of the Wall Street Journal reported last
Federal Reserve Board governor Daniel Tarullo said Wednesday that
he opposes the "provocative idea" of getting banks out of the business of
trading risky securities so they can focus on lending.
In a speech to a business group, Tarullo said he doubted any such ban would end
the problem of too-big-to-fail institutions, laying out a pair of objections to
the idea of legislation intended to split banks up by their lines of business.
For one thing, Tarullo said, splitting them up wouldn't end too-big-to-fail
concerns because banks have shown the ability to get into trouble through risky
Moreover, trading in higher-risk securities would have to go somewhere else if
banks couldn't engage in such activities and wherever it went, the
too-big-to-fail problem would go along with it, he said. (Wall Street Journal,
October 21, 2009.)
Instead, the camp to broaden regulatory
powers and allow greater government supervision is the supposed panacea,
according to Tarullo and his kind. The speech to the Exchequer Club made by
Tarullo makes the following recommendations:
First would be creation by
Congress of a special resolution procedure for systemically important financial
firms ... A related innovation would be a requirement that each major financial
institution draw up and submit for approval to its supervisors a plan for
orderly wind-down in the event of serious liquidity or solvency difficulties.
A second kind of market discipline initiative is a requirement that large
financial firms have specified forms of "contingent capital." ... a regularly
issued special debt instrument that would convert to equity during times of
financial distress could add market discipline both through the pricing of
newly issued instruments and through the interests of current shareholders in
A third improvement in market discipline could come through judicious extension
of disclosure requirements for regulated financial institutions. Disclosure
requirements have at times served as too easy an answer to calls for market
discipline ... However, an organized inquiry of actual and potential investors
might identify discrete categories of information thought to have particular
salience for purchase and pricing decisions.
Tarullo may have
been living on a different planet than I have over the past year or so. For
about the one thing that "investors" as a group have shown over the past year
with respect to all classes of bank securities (senior debt,
subordinated debt, hybrid capital and equity prices) has been the extremes of
fear and greed.
This has been, I hasten to add, not so much a function of the inefficiency of
markets per se, but rather the swings caused by the act of second-guessing
government intentions at every juncture; in other words, it becomes virtually
impossible to assign a fair market price to anything that is essentially a
derivative product of political whim.
Given that, specifically what manner of "organized inquiry" does the good
governor suggest exactly?
Rather than providing comfort, the speech filled me with dread - the notion
that the US government had effectively capitulated to the bank lobbies, and
decided to hide behind the facade of market-based solutions to what is
essentially a government-created problem.
In comparison to this wishy-washy approach, the solution promoted by the EU is
the very model of clarity, on the lines of "none of us understands these large
monsters, so we will rather deal with a large number of small monsters than
continue having the opposite problem". So there you have it - the Europeans
have finally done something smart enough to make the American stewardship of
the global financial system appear not only irresponsible but also untenable.