The Fed Bails Out Eurobanks Yet Again

Watching re-enactments of scenes from the global financial crisis is a very peculiar experience indeed. The opening by the Fed of currency swap lines to allow the ECB and other central banks to extend dollar funding to Eurobanks was seen as an extreme measure the first time around, a sign of how close to the abyss the financial system had come. This time, allegedly because the powers that be acted before things got quite so dire, bank stocks rallied impressively. Similarly, the media treated this move as just another episode in the ongoing Perils of Pauline drama running on the other side of the Atlantic. The $2 billion loss by a UBS rogue trader got far more extensive coverage, even though rogue traders also seem to be all of a muchness.

Now narrowly, the jaundiced media response and the market bounce both make sense. The Eurodrama has gone so many chapters that it’s easy to get rescue fatigue. And a bailout handled tidily among central bankers makes for less gripping reporting that the national and interpersonal theatrics involved in the typical Eurozone cliffhanger. Similarly, the Eurobanks were under real stress by being frozen out of dollar funding, largely because US money market funds were no longer willing to do repos with them or buy their commercial paper. And US banks were also encouraged to cut back on their exposures to them. So the central banks have stepped into this breach.

But this is just a liquidity fix, and here, that means largely a palliative. The Eurobanks will suffer serious hits when the sovereign debt crisis losses come home to roost; this alone will render many major banks undercapitalized. The ECB has, as the Fed did, allowed banks to pledge dreckly collateral in return for shiny new funds. But the big difference between the ECB and the Fed is the ECB apparently sees itself as constrained by its $5 billion in equity (even though it could simply print, give the proceeds to national governments, and have them give that back to the ECB as an equity contribution) and is loath to bloat its balance sheet too much. The self imposed balance sheet growth limits of the ECB plus the refusal of EU leaders to consider other mechanisms such as Eurobonds means it’s hard to see how the wheels are not going to come off the European financial system in the not too distant future.

The UBS saga provided a stark reminder that the visible sovereign credit risk is not the only peril facing these banks. In the crisis, it wasn’t one problem that felled banks; it seemed like everything came apart in quick succession. The UBS losses were on a desk that took ETF-related exposures, something that regulators have belatedly realized has concentrated a lot of risk in already highly leveraged dealer banks. This situation sounds scarily like a rerun of the CDO saga of the crisis. Gillian Tett has the same reaction:

Consider the parallels. On paper, ETFs (just like CDOs) look like a wonderful idea…So, unsurprisingly, the sector has exploded: annual growth over the past decade has been 40 per cent on average…Indeed, if you look at the charts tracking ETF growth in the past three years, they look extraordinarily similar to the CDOs charts back in 2005: the lines all point to the sky.

But, as with CDOs, this growth has come at a cost. Although the first generation of ETFs were very stodgy – composed of cash equities, say – more recently banks have started creating more exotic structures to boost returns…Worse still, potential conflicts of interest have emerged within the banks too: not only do banks sell ETFs to their clients, but they also manage the trading flows that occur when the portfolios are hedged and rebalanced..

Of course, in theory, senior bank managers should be able to monitor this. But, as ever, cultural and structural problems have sometimes prompted them to look away: precisely because ETFs have been labelled as “safe” and “transparent” by the industry, they have not featured as a danger spot on risk managers’ radar screens. Once again, there may be echoes of those CDOs: one reason why UBS racked up such vast losses in 2007 on CDOs, for example, was that AAA-rated CDOs were classified as safe and profitable in internal risk management reports – and nobody felt any need to probe.

This is a long-winded way of saying crises have a nasty way of exposing weaknesses that regulators and bank managers themselves had managed to downplay (in fairness, regulators are pretty worried about ETFs but they haven’t moved to rein them in).

The other distressing aspect of this saga is that we have cross border regulatory action without effective cross border/supranational regulation. Responsibility (for cross border bailouts) without authority is not a good combination. Even though the rationale for the Fed helping save the Eurobanks’ hide is that the risk is small and a Eurocrisis would hurt US banks, it’s not good practice to save entities you don’t oversee. And it’s even more troubling to have this done by central banks, who have enormous power yet very little accountability in a nominally democratic system.

So this not-so-little rescue serves as a reminder of what we on some level know all too well: despite the desperate need for reform in the wake of the crisis, too much appears to remain just the same as before.