REFORM AND NATIONALISATION OF BANKS – The need for a new EU action plan and why nationalisation of banks may be necessary in the short to medium term. SOME OBSERVATIONS ON FINANCIAL SERVICES AND THE NEED FOR A NEW EU ACTION PLAN. (Extract from CEPS Commentary 21.10.08) ON THE PRUDENTIAL SIDE It is clear that the Basel ratios have not provided a clear indication of the true level of risks in banks. European supervisors have focused far too narrowly on one measure, the risk-weighted capital ratios as proposed by the Basle Committee, which allowed banks in trouble to claim they were solvent. The Belgian bank Dexia is a case in point. While the bank had a Basel Tier 1 ratio of 11.4% in June 2008, it had a core capital ratio (core capital divided by all – not riskweighted – assets) of only 1.6%! This is well below the 2% closure rules used by US supervisors. The use of the Basel ratio should thus in the future be complemented with a crude capital (or leverage) ratio, a liquidity ratio, an asset diversification ratio and a governance index, as key indicators of the soundness of a bank. The recapitalisation of banks should be directly linked to a firm commitment by the banks to meet minimum levels by a certain time. ON THE INSTITUTIONAL SIDE Policy-makers need to come up with a much more integrated structure for financial oversight in the EU than what is in place at present. The loose cooperation structure and the limited coordination in the supervisors’ secretariats have clearly shown their limitations. Banking markets are much more interconnected than are the supervisors, and the lack of stricter European-wide oversight affects the competitiveness of the European banking sector as a whole. The new Committee set up by the European Commission and chaired by Jacques de Larosière, should aim to modernise the EU’s regulatory structure, through the creation of a European System of Financial Supervisors (ESFS). Under an ESFS, EU supervisors would work under a single umbrella and within a single institutional structure, on the basis of harmonised principles and statutes, but respecting subsidiarity where needed. Hence crisis management, supervision of large, systemically important institutions and data-pooling would be executed at the centre, whereas the control of consumer protection and conduct-of-business rules would be left with the member states. The de Larosière group will also have to come up with a model for burden-sharing of failures of European-wide banks. This is no longer problematic only for the smaller countries, but also for the larger member states, where the growth prospects of the financial sector will be compromised for some time to come unless a European plan exists. The top five banks in the UK, for example, represent more than three times the country’s GDP and a large part of their assets and activities are outside the UK. It would thus be prohibitively costly for the UK government to save its banking system on its own, but it would also not be appropriate as the benefits from saving UK banks would accrue to all those countries where UK banks operate. ON THE PRODUCT REGULATORY SIDE There is much in need of upgrading and redesign, which will become even more apparent as the dust of the crisis settles. In retail finance, for example, much work needs to be done on the deposit protection schemes, fund regulation and mortgage regulation. Further to the agreement in the Ecofin Council of October 7th, a proposal was made by the European Commission to increase the minimum level of deposit protection schemes to €100,000. But the proposal does not harmonise the statutes of the national regimes, nor does it harmonise the ways of funding. It also does not satisfactorily resolve the home-host country conflicts. Work is ongoing regarding the supervision of funds, but the current turmoil has demonstrated that the rules on eligible assets and asset segregation leave much to be desired. A new, more principles-based framework for fund management in the EU would be preferable. As for mortgage credit, more binding legislation will be needed to enforce responsible lending and the use of reasonable loan to value ratios. Apart from this regulatory fine-tuning, the European Commission’s competition policy department will have a huge task in scrutinising the application of different national bail-out plans and confining the single market damage. Some have argued that the financial crisis has set back progress in EU integration by 15 years. The EU can demonstrate that this is not the case by rapidly drawing the lessons from the crisis and taking it as a challenge for a further step in European integration. Doing so will require plenty of effort and determination, but it will certainly benefit the EU’s financial services industry and economy. -------- NATIONALIZING BANKS TO JUMPSTART THE BANKING SYSTEM (By Paul De Grauwe, Professor of Economics at the University of Leuven and Associate Senior Fellow at CEPS.) CEPS Commentary/10 October 2008 The essence of what banks do in normal times is to borrow short and to lend long. In doing so, they transform short-term assets into long ones, thereby creating credit and liquidity. Put differently, by borrowing short and lending long, banks become less liquid, thereby making it possible for the non-banking sector to become more liquid; that is, have assets that are shorter than their liabilities. This is essential for the non-bank sector to run smoothly. This credit transformation model performed by banks only works if there is confidence in the banks and, more importantly, if banks trust each other. This confidence has now evaporated and, as a result, the model fails. The generalised distrust within the banking system has led to a situation where banks do not want to lend any more. That means that they continue to borrow short but lend equally short; that is, acquire the most liquid assets. The result is a massive destruction of credit and liquidity in the economy. The non-banking sector cannot borrow long so as to acquire liquid assets that they need to run their business, because banks do not lend long anymore. This risks bringing the economy to a standstill. A depression is looming. It is important to realise that this liquidity crisis is the result of a co-ordination failure: bank A does not want to lend to bank B, not necessarily because it fears insolvency of bank B but because it fears other banks will not lend to bank B, thereby creating insolvency of bank B out of the blue. Thus bank lending comes to a standstill because banks expect bank lending to come to a standstill. How to get out of this bad equilibrium? There is only one way. The governments of the major countries (US, UK, the eurozone, possibly Japan) must take over their banking systems (or at least the significant banks). Governments are the only institutions that can solve the co-ordination failure at the heart of the liquidity crisis. They can do this because once the banks are in the hands of the state, they can be ordered to trust each other and to lend to each other. The faster governments take these steps the better. Government interventions have consisted of recapitalising banks. These have not worked. The main reason is that they have been triggered by bank failures as they pop up and, as a result, have only dealt with the symptoms. The liquidity crisis is pulling down asset prices in an indiscriminate way, thereby transforming the liquidity crisis into solvency problems of individual banks. The governments then are forced to step in and to recapitalise the bank only to find out later that when the liquidity crisis strikes again, the capital has evaporated. The governments throw fresh capital into a black hole, where it disappears quickly. Central bank liquidity provision, although necessary, has also failed to address the coordination failure and has only made it easier for banks to dispose of long assets to acquire short ones (cash). Thus central banks’ liquidity provisions do not stop the massive destruction of credit and liquidity that is going on in the economy. The recent decision of the US Federal Reserve to bypass the banking system and to lend directly to the non-banking sector by buying commercial paper is a step in the right direction. It allows companies to obtain cash by borrowing long; a service banks do not want to provide anymore. The step taken by the Fed is insufficient, however. The Fed cannot take over all bank lending operations. Only the government can do this by temporarily transforming private banks into public ones. It can then order the management of these state banks to lend to each other. Such a transformation (call it a temporary nationalisation) will make it possible to jump start the interbank market and allow the normal flow of credit to be activated. Nationalising the banking system is not the only intervention necessary. There is today a general distrust of private debt. This will force the government to substitute private debt for public debt. The Paulson plan does just that. More Paulson plans will be necessary to put a floor on the price of private debt and to prevent a meltdown. The temporary nationalisation of the banking system and the substitution of private debt by public debt will allow us to reach a new equilibrium. When this happens, a fundamental reform of the banking system will be necessary in order to remain in this benign equilibrium. When this is achieved the governments will be able to privatise the banking system again. ID: 42028 Author(s): SCR Publication date: 21/10/08

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