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| Twin Crisis: Sovereign Debts and Banks |
1.) how are banks and sovereigns being locked up together in this crisis?
2.) how cross-country banking should be？How might it help to cope with the problem？
3.) Is there any possibility to design a new financial instrument, specifically, a repackaged debt instrument, to tackle the current crisis？
National Bias of Bond Holdings：Sovereign Bonds Locked in
First of all, Let's take a look of current situation. How tightly-knitted in between national banks and their government? This histogram offers us basic understandings.
70% of Spain/Greece/Italy national debts are held by the national banks. What would this imply, or how we end up here?
1.) National governments rely more heavily on national banks. When the debt crisis comes, international investors started pulling out of the inflicted economies. These government cannot tap into international debt markets, Only did their national banks hold such securities. The result? Such concentration could worsen the current situation as shown above, the twin-crisis linkage can actually goes tighter.
2.) Banks in these countries would trap even further with their national government
Such situation further deteriorates the asset quality of these banks.Facing with such negative impact, banks would cut bank lending to private sector, or even have to recapitalize themselves with higher rate. The whole economy would go to the downward spiral.
Current rescue package, LTRO(Long Term Refinancing Operation) could worsen this lockup. The key feature of LTRO is a low-interest, long-term(3 year) financing from ECB to banks. This funding program will help banks improve their balance sheet, by either purchase two key components on the asset side: "the sovereign debt" or "loan to firms"
If this funding goes to private sector, it might help the economy to revive with some more vigorous business activities. However, most of the funding is expected to plow into the new national securities issued in the crisis period. It will, in a way, secure the funding needs of these banks and keep the national governments afloated.
Second: How cross-border banking should alleviate, or prevent the crisis.
The key idea is, if cross-border banking works, then, the cash-flows of national banks would be more "balanced" or say, "diversified". In other words, such concentration should not happen at the first place.
Let's imagine: If the asset classes holding by banks, or say, the cashflows of banks, are not that concentrated on their home territory, these banks can function better in the situation when a national debt crisis comes in picture. Since the banks can still carry out their function as lender to support the private sector, the economy as a whole won't suffer as much.
Then how banks can diversify their asset class? They could step into another territory and operate there. Then they will naturally hold on the assets in another countries. Another way is, to create a "pan-European" bond class for them to hold. Then it would naturally help them to diversify when they purchase such securities. Such ideas come into the third steps: create a new European risk-free assets.
Third: How to loss up such knot? A proposal of a new form of risk-free security.
Now there are two suggestions
1. A joint Bond mutual fund: (Beck, Uhlig and Wagner,2011)
2. A new-type of risk-free asset (ESBies: European Safe bond)
Both could be viable. However, it would be a matter whether ECB is going to take on this approach. And this would also be a matter whether the national governments feel their fiscal autonomy has kept intact with these securities.
Reference:
Brunnermeier, Markus K, Luis Garicano, Philip R Lane, Marco Pagano, Ricardo Reis, Tano Santos, Stijn Van Nieuwerburgh, and Dimitri Vayanos (2011), “European Safe Bonds: ESBies,” Euro-nomics.com
2.) Banks in these countries would trap even further with their national government
Such situation further deteriorates the asset quality of these banks.Facing with such negative impact, banks would cut bank lending to private sector, or even have to recapitalize themselves with higher rate. The whole economy would go to the downward spiral.
Current rescue package, LTRO(Long Term Refinancing Operation) could worsen this lockup. The key feature of LTRO is a low-interest, long-term(3 year) financing from ECB to banks. This funding program will help banks improve their balance sheet, by either purchase two key components on the asset side: "the sovereign debt" or "loan to firms"
If this funding goes to private sector, it might help the economy to revive with some more vigorous business activities. However, most of the funding is expected to plow into the new national securities issued in the crisis period. It will, in a way, secure the funding needs of these banks and keep the national governments afloated.
Second: How cross-border banking should alleviate, or prevent the crisis.
The key idea is, if cross-border banking works, then, the cash-flows of national banks would be more "balanced" or say, "diversified". In other words, such concentration should not happen at the first place.
Let's imagine: If the asset classes holding by banks, or say, the cashflows of banks, are not that concentrated on their home territory, these banks can function better in the situation when a national debt crisis comes in picture. Since the banks can still carry out their function as lender to support the private sector, the economy as a whole won't suffer as much.
Then how banks can diversify their asset class? They could step into another territory and operate there. Then they will naturally hold on the assets in another countries. Another way is, to create a "pan-European" bond class for them to hold. Then it would naturally help them to diversify when they purchase such securities. Such ideas come into the third steps: create a new European risk-free assets.
Third: How to loss up such knot? A proposal of a new form of risk-free security.
Now there are two suggestions
1. A joint Bond mutual fund: (Beck, Uhlig and Wagner,2011)
2. A new-type of risk-free asset (ESBies: European Safe bond)
Both could be viable. However, it would be a matter whether ECB is going to take on this approach. And this would also be a matter whether the national governments feel their fiscal autonomy has kept intact with these securities.
Reference:
Brunnermeier, Markus K, Luis Garicano, Philip R Lane, Marco Pagano, Ricardo Reis, Tano Santos, Stijn Van Nieuwerburgh, and Dimitri Vayanos (2011), “European Safe Bonds: ESBies,” Euro-nomics.com
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