Europe’s Response to the Market Meltdown

Following the week-long debate among US policy makers over the nation’s recovery plan, it was the turn of Europe’s leaders to discuss their response to the crisis over the last few days. One message that came through from the crisis talks is that there is unlikely to be a European equivalent of the Troubled Assets Relief Programme (TARP) in the US – the $700bn US recovery plan to buy troubled assets from ailing financial companies (read more in the news focus story: #gtnFeature(318)#). The German chancellor, Angela Merkel, underlined this point by saying: “Those who caused the trouble must be made to help sort it out”. It has also become clear that while the leaders have committed to taking a co-ordinated approach to current market turbulence verbally, in reality, each country has handled the crisis within their own borders unilaterally.

This was first highlighted by Ireland’s announcement last week that it would issue a blanket guarantee for two years on all deposits at six of its banks and other creditors including bondholders. Ireland’s decision quickly created a domino effect with Denmark and Greece announcing that they would provide unlimited guarantees to savers and Sweden also increasing the amount of protection it offers. In the UK, the limit on the amount of deposits that are guaranteed should a UK bank go bust will go up from £35,000 to £50,000 per banking group, from today.

Will this ethos of ‘every country for itself’ jeopardise long-term plans to resolve the crisis in Europe? Not according to Bob McDowall, research director at TowerGroup, who says that a pan-European approach to the crisis is something that Europe does not need and will not have.

“The European nation states are acting unilaterally and, where necessary, bilaterally in their attempts to bring stability to their domestic financial systems and re-engender confidence of depositors and investors in financial institutions, where they are the home regulator,” he said in an interview with gtnews. “We need firm collective leadership from nation states where an institution impacts on systemic risk in more than one country.”

He believes any intervention from the European Commission, for example, would add an unnecessary level of bureaucracy. “Prompt decisive action is required. The European Commission is not structurally equipped to provide strong decisive action,” he argues. McDowall is more supportive of the European Central Bank (ECB), which he says plays a pivotal role in the marshalling and co-ordination of liquidity in Europe through the bilateral arrangements it has in place with national central banks.

“We have already seen countries acting on a co-operative, bilateral basis where necessary, such as in the case of Fortis and Dexia, where the Benelux countries took action,” he says. Belgium and Luxembourg were forced to find a buyer for what remained of Fortis, after the Netherlands government nationalised the bulk of the group’s Dutch businesses in a sudden move on Friday. A deal announced by the Belgian government on Sunday night will now see the French bank, BNP Paribas, take control of the remaining assets. (Read more about bank consolidation in the commentary: Effective Risk Management Must Underpin Bank Consolidation

“Fortis was the weakest link in the bid for ABN AMRO because of its exposure to the US sub-prime crisis but it does have some strong niche businesses that will inevitably be sold off, as evidenced by the sale of its Belgian insurance business to BNP Paribas,” affirmed McDowall.

And Fortis will not be the last European institution in need of rescue. A second bail-out package was agreed by the German government and financial regulators for property lender, Hypo Real Estate, over the weekend after the first attempt to rescue it failed. The success of this bail-out package is vital because the potential collapse of Hypo would have detrimental consequences for the entire European market, as it is one of Europe’s biggest commercial property lenders with a €400bn balance sheet.

Right now, Iceland faces the most serious repercussions of the credit crunch on this side of the Atlantic with the country’s parliament passing emergency legislation to try to salvage the country’s banking system following the earlier decision to temporarily halt all trading in six of Iceland’s biggest banks and financial firms. Last week, the government stepped into nationalise Iceland’s third largest bank, Glitnir, and this morning it took control of the country’s second largest bank, Landsbanki. (Stay up-to-date with the latest changes in the global banking industry here: The Credit Crisis Timeline

Figure 1: Current State of the Global Banking Industry

Source: BBC News, 7 October 2008

Banks Seek State Funding

State-ownership or strong state shareholding looks set to be a banking model that will only increase over the next few weeks and months in Europe and the US. So far, Fannie Mae, Freddie Mac, Fortis and Bradford & Bingley have all been nationalised with the Icelandic banks quickly following suite.

For TowerGroup’s McDowall, history is simply repeating itself. “Twenty-five or 30 years ago, a number of European banks were either state-owned or had strong state shareholding as a result of the European financial crisis in the 1930s or as part of post-war reconstruction,” he said. “They operated conservatively under state ownership, which is an indication that this model is not necessarily a bad thing.”

How many banks will eventually succumb to nationalisation is unknown but there is no doubt that there will only be more rigorous supervision of the industry’s financial institutions, as well as increased regulatory pressure around the risks on their balance sheets.

Accountability Must be Upheld

Risk management is not just about systems and processes, though; it is also about accountability and the mindset of decision-makers within banks about the risk they are willing to take. “I don’t believe the crisis we are facing today is due to poor systems and processes. Companies started implementing industrial strength credit risk systems in the 1990s so there are mature processes in place within these institutions,” said Nigel Walder CEO at Business Control Solutions (BCS) in an interview with gtnews. The real problem stems from the fact that, within the investment business, it has traditionally been the trading partners that have had the upper hand due to the revenues they generated and therefore, at executive level, the necessary controls over the amount of credit risk an institution has taken in the past was not adequately exerted or enforced.

“As a result, in future, compensation schemes will be much more aligned for the greater good of the firm rather than individual’s annual bonuses,” says Walder. “There will also be much more stringent risk management discussion and evaluation of these financial institutions.”

While the global markets face a plethora of problems with the volatility in the stock markets, continued collapses and acquisitions among financial institutions, the lack of liquidity and an overall lack of confidence in the markets, it might seem glib to say that implementing a more stringent supervisory framework and controls around the risks on a company’s balance sheets may well be the easy part. What seems to be much more daunting is addressing the accountability for decisions made within institutions and the culture of bonuses and remuneration that caused the current crisis.

The size of this task is underlined by the fact that, Richard Fuld, the head of failed US investment bank, Lehman Brothers, told the US Congress just yesterday that he took home about US$300m in pay and bonuses over the past eight years and it was true that, at the same time as requesting a federal rescue from the government, he also requested multi-million dollar bonuses for departing executives just days before Lehman’s collapse. Fuld also continued to defend his actions as “prudent and appropriate”. If the head of Lehman’ Brothers – the institution whose collapse started the financial turmoil in recent weeks and which finally led to the US$700bn recovery plan – is still unwilling to admit his part in this crisis, is that a sign that the mentality of banks and their senior executives will never really change? And if so, what does that mean for the stability and future of our financial markets?

Read about how corporates are dealing with the credit crunch in the commentary: Finding Best Practice for Corporate Treasury in the Deepening Credit Crisis


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