The specter of Lehman Brothers continues to haunt policymakers. Nowhere is its presence more apparent than the euro zone, where twin banking and sovereign debt crises are raging.
“In the worst case, a debt restructuring of a euro zone member could put the consequences of Lehman’s bankruptcy in the shade,” Jürgen Stark, the European Central Bank’s chief economist, warned on German television at the weekend, the latest to summon the spirit of the failed US investment bank.
This fear of sparking the next Lehman is paralyzing policymakers when faced with some of the biggest problems in the euro zone.
Two tough decisions loom largest: can a bank be allowed to fail fully and could a country restructure its debt, without both causing huge damage to the financial system? On current evidence – and having spent recent weeks talking to a number of European policymakers – there is a danger of both questions being answered wrongly.
To hear regulators talk about banks today and how they should be in the future is to be presented with a world where no bank can fail versus a vision where any bank can fail. In the current imperfect world, no bank can currently impose losses on senior bondholders.
The mess surrounding Irish banks including Allied Irish and Bank of Ireland has thrown the problem into sharp relief. In spite of being tiny and relatively insignificant banks in euro zone terms – nowhere near as systemically important as Lehman was – European policymakers are petrified to act.
“We can’t risk another Lehman,” one says.
In the next breath, however, he extols a future banking system under which concepts such as “bail-in” or “contingent capital” will allow, in his words, “any bank to fail”.
The gulf between where we are and where regulators want to get to seems so wide it raises the question of whether it can ever be bridged.
For many investors, the answer is simple: the Irish banks should be allowed to fail with senior bondholders taking a hit. If the market is well prepared, financial calumny should be avoided and regulators would have set an important precedent.
If you want to allow a Barclays or a Deutsche Bank to fail in the future, then you want to start on a small bank with limited links to other big institutions, rather than experiment on a systemically important institution. One of the Irish banks, therefore, would seem an ideal candidate with which to start.
A sovereign debt restructuring is knottier. Another relatively small entity stands at the center of this debate: Greece. As its bond yields have shot ever higher this week, investors are already signaling the likelihood of some kind of restructuring. Greek 7-year bond prices traded at a low of just 51 percent of full value on Wednesday, down significantly over the past month.
The debate among investors is mostly over timing. Some believe that Greece should restructure quickly to ease the burden domestically. They argue that the knock-on risks from a restructuring have diminished in recent months as Spain has decoupled from the other members of the troubled periphery while European banks should be in a position to absorb losses.
Others argue that it makes little sense for Greece to restructure now. It should instead wait until it is at least in a primary surplus – as measured by government spending less tax revenues, excluding the burden of interest payments. Then a “haircut” of 50-70 percent on its debt would restore Greece to sustainability.
The ECB, though, is having none of it. Mr. Stark warns that a restructuring could have a negative impact on the whole European banking system, much as Lehman did. Greek banks could well implode.
European policymakers also say that the US remains implacably opposed to any restructuring, be it sovereign or bank. In their view, the Americans would like the Germans to drop all talk of restructuring. Instead, the endgame would be a full-blown euro zone fiscal union.
But such thinking is politically unpalatable in northern European countries. So something different is needed.
Some investors argue that the fallout from Lehman was as much the result of their not knowing which banks were safe as the failure itself. If that reading is correct, the upcoming bank stress tests are an opportunity.
If they are credible, tough and transparent, especially on the crucial question of sovereign debt holdings in both the banking and trading books, then there is a good chance that a sovereign restructuring or the failure of a small bank would be accepted by the markets.
Policymakers need to get over their fear of Lehman. Clearly nobody wants to spark the next crisis. But the current imperfect world, where bondholders of banks and nations are shielded from suffering any pain, cannot last. Something has to give.