Financial contagion spreads to Europe
Is blanket deposit insurance the right way to put out the fire?
By Jon Fernquest |
Financial contagion spread to Europe this week like a wildfire.
The government rescue of the mammoth Hypo Real Estate in Germany floundered.
The rescue of Fortis by the Dutch, Luxembourg and Belgian governments hit snags too (Read The Economist).
Nationalization of a large chunk of the European financial sector seems imminent:
Once a bank is seen as vulnerable it appears that there is little, short of nationalising it, that can be done to regain the confidence of those on whom it relies for funding.
European banks appear to have a bigger problem than the US:
The liabilities of the biggest US bank equal half the US tax revenues; the ratios in Europe are bigger. Deutsche Bank's liabilities are one and a half times Germany’s annual tax revenue; Barclays' are twice Britain’s (Source: Avinash Persaud 06-10-08 October 2008, Vox EU, link).
Tiny Iceland is an extreme case of over-exposure to financial risk:
Its economy had been doing well, but its banks had expanded rapidly abroad, amassing foreign liabilities some ten times larger than the country’s economy, many funded in fickle money markets. Since the country nationalised Glitnir, its third-largest bank, last week the whole Icelandic economy has come under threat. Its currency is tumbling and the cost of insuring its national debt against default is soaring. As of Monday it was desperately calling for help from other central banks and was considering radical actions including using the foreign assets of pension funds to bolster the central bank’s reserves. These stand at a meagre €4 billion or so, according to Fitch, a rating agency, and in effect are now pledged to back more than a €100 billion in foreign liabilities owed by its banks (Source: The Economist and read article)
Is blanket deposit insurance the solution?
Ireland, Germany, and Denmark have extended blanket deposit insurance to all retail banking accounts and other European countries increased the amount of deposits that are insured.
Sudden changes like this can make deposits more volatile and may even encourage the recklessness that led to the crisis in the first place. Whether such blanket deposit is feasible is also questionable:
...it is not entirely clear how governments would pay these bills, if they ever came due. The chances of governments having to make good on all deposits seems remote, but the figures involved are eye-popping. In Ireland, for instance, national debt would jump from about 25% of GDP to about 325% if the value of its banks' deposits and debts were taken on to the government’s books, according to analysts at Morgan Stanley, an investment bank. Similarly in Germany, national debt would jump to almost 200% of GDP if it included bank deposits (and about 250% if it included all the debts of its banking system). This may explain why interest rates on Irish government bonds have been rising in recent days (Source: Economist).
Robert Reich, former US Secretary of Labour, finds the The European deposit insurance solution more appealing than the US rescue package:
Several nations (Ireland, Greece, Germany) have basically guaranteed all deposits. As a result, global capital is moving their way. They're also thereby creating a new form of socialized capitalism. At the rate they're going, these nations will soon own and run their financial markets, and maybe a big chunk of the world's (Source: Robert Reich, link).
Paul Krugman's "international finance multiplier"
The last week provided new evidence of how the economies of different countries are highly linked (international linkages) and dependent on each other (interdependence).
In the past imports, exports, and the foreign trade multiplier have been used to explain international linkages to economics students: "country A's GDP affects its level of imports, which are country B's exports, so demand shocks get transmitted through international trade" (Read Krugman's international finance multiplier paper cited in Economist's View).
The sudden spread of the financial contagion to Europe prompted Paul Krugman to propose an international finance multiplier in which "changes in asset prices are transmitted internationally through their effects on the balance sheets of highly leveraged financial institutions."
Vocabulary:
a contagion - when a disease spreads rapidly from contact with other people
a financial contagion - when a financial crisis and a sudden fall in asset prices spreads rapidly from country to country
blanket - includes everything and everyone (without exceptions)
deposit insurance - when the government promises to pay back depositors if a bank fails (a safety net that promotes financial stability in an economy) (See Wikipedia)
blanket deposit insurance - all deposits are insured for full amount
a wildfire - a fire that spreads rapidly
mammoth - very large (like a prehistoric mammoth)
Hypo Real Estate - a large German company which owns real estate banks, the second largest commercial property lender in Germany, businesses include commercial property, infrastructure and public finance, and capital markets and asset management (See Wikipedia)
floundered - has many problems and may fail completely soon
Fortis - a banking, insurance, and investment management company, and is the 20th largest business in the world by revenue, home base is in the Netherlands and Belgium (See Wikipedia)
hit snags - have problems, encounter problems along the way
nationalization - making a private company into a government owned company
imminent - will happen shortly
there is little, short of nationalising it, that can be done - nationalising it is about the only thing that can be done
liabilities - money owed to others
fickle - changing often and unreliable
fickle money markets - money markets changing often and unreliable (the current situation)
over-exposure to financial risk - runs a very great risk of losing money on the financial assets it owns
Glitnir - the third largest bank in Iceland (See Wikipedia)
insuring its national debt against default -
desperately - in a very bad situation and willing to try anything
pension funds - money being saved for when employees retire
bank reserves - assets held by a bank to fulfill its deposit obligations
fractional-reserve banking - when banks keep only a fraction of the value of their deposits in reserve and invest the rest in interest earning assets while maintaining the obligation to pay back all deposits upon demand, a universal practice in modern banking (See Wikipedia)
reserves - the reserves of the fractional-reserve banking system above
the central bank's reserves - assets held by the central bank to fulfil its obligations
bolster - add to, increase
bolster the central bank's reserves - increase the reserves of the central bank
Fitch, Fitch Ratings - an international credit rating agency, recognized by the U.S. Securities and Exchange Commission (SEC) together with Moody's and Standard & Poor's (See Wikipedia)
a rating agency - a company that gives other companies and their debt a rating that measures how likely they are to not pay the money back
retail banking - banking services to small account holders offered through bank branches such as savings and checking accounts and personal loans (See Wikipedia)
retail banking accounts - the bank accounts of small customers
recklessness - not caring about danger or harm to others (acting wildly)
feasible - is possible to do
came due - time for paying what you owe has arrived
make good on - do something you say you were going to do (like pay back a loan)
figures - numbers, statistics
eye-popping - very surprising
guaranteed all deposits - promised to pay back all bank deposits to people if banks cannot pay
a multiplier effect - when an initial effect grows bigger and bigger
international finance multiplier - when changes in asset prices (bubble, bust) in one country are transmitted internationally through their effects on the balance sheets of highly leveraged banks
foreign trade multiplier - when changes in economic activity (demand) are transmitted through international trade (because "country A's GDP affects its level of imports, which are country B's exports")
highly leveraged - borrowed a lot of money to purchase something (with very little initial payment)
international linkages - ways that an economy of one country can have an effect on the economies of other countries
interdependence - when a group of people or things all depend on each other
