Greek lesson to banking world

Banking crisis: People line up outside the Deposits and Loans Fund in Athens to request loans settlements or proceed with bank transactions. Many of the measures Greece’s creditors have imposed on the country have been self-defeating. The biggest blunder they have made is the systematic destruction of the banking system. – EPA

With its damaged banking system, Greek recovery will be a Sisyphean task

SISYPHUS, the king of Ephyra (now Corinth), was condemned by the Greek gods to push a boulder up a hill, only to watch it roll down again and again, experiencing an eternity of futility and endless effort.

Mimicking the Greek gods, European leaders seem to want to condemn Greece to the same fate, with their never-ending negotiations, bureaucratic wrangling and half measures to address that country’s longstanding debt crisis.

Each round helps Greece move forward momentarily only to fall back into a downward slide of negative economic growth.

The foundation of western civilisation has been crumbling as politics has trumped good policy, with key decision makers unwilling to make the hard decisions necessary to put Greece on a sustainable path.

Many of the measures Greece’s creditors have imposed on the country have been self-defeating, particularly in prioritising austerity over pro-growth reforms.

But perhaps the biggest blunder they have made is the systematic destruction of the banking system. Greece will never make good on its debt obligations even with the latest grant of extensions – until it can get its economy growing again.

And real economic growth is impossible for any country which lacks a stable banking system. Fractional reserve banking only works if depositors have the confidence to keep their money in banks and banks have sufficient capital and liquidity to lend. This is why it is essential for developed economies to have credible deposit insurance systems and central bank lending facilities, so that the public knows their bank deposits are safe and banks know they can convert some of those short-term deposits into longer-term loans to consumers and businesses, confident that they will have access to liquidity, if needed, through central bank backstop lending facilities.

But Greece lacks a credible deposit insurance system, and it has been whipsawed by central bank ambivalence in fully backing its banks. These problems are symptomatic of the larger issue of Europe’s schizophrenic attitude toward true banking union. They say they want it, but are unwilling to take the bold steps necessary to get there.

First and foremost, Europe needs a single deposit guarantee mechanism which would place the collective might of EU members behind the insured bank deposits of member country institutions. Deposit insurance can only work if the guarantee is credible, and the guarantee can only be credible if a strong sovereign ultimately backs it.

This has been the key to the success of the Federal Deposit Insurance Corp (FDIC), which has successfully avoided bank runs for over eight decades. While funded by the banks it insures, its deposit guarantee is ultimately backed by the full faith and credit of the US government.

However, in Europe, notwithstanding lip service to banking union, insured depositors must look to their local national governments for ultimate protection, and in a troubled state like Greece, depositors have little confidence that their government can protect them. For years, Greek banks have suffered from a deposit “trot” – a slow and constant erosion of their deposit base as the Greek government’s solvency issues remain unresolved.

Contrast the Greek situation to that in Puerto Rico where the government also struggles with insolvency, but bank deposits have remained stable, because of the FDIC’s backing of depositors at the federal level. Making matters worse, the trot in Greek deposits accelerated to a full blown run last summer as brinksmanship between the newly-elected government and its “troika” of creditors – the European Commission (EC), the European Central Bank (ECB), and the International Monetary Fund (IMF) – reached a fevered pitch.

The ECB, apparently placing its allegiance to fellow creditors ahead of its responsibilities to maintain system stability, froze funds available to Greek banks under its Emergency Liquidity Assistance programme. This raised questions about their soundness, even though eight months earlier, the ECB had essentially declared those same Greek banks healthy and fit enough to survive stressed economic conditions.

The ECB’s power play worked – Greek voters approved the plan the creditors wanted – but the price to the Greek economy was high. Depositors accelerated their withdrawals, necessitating a three-week bank “holiday” and imposition of severe capital controls. The disruptions to the payments system and credit availability worked a tremendous hardship on Greek consumers and businesses, worsening an already troubled Greek economy.

This was a serious misstep in what has otherwise been a flawless performance since the financial crisis by ECB chairman Mario Draghi. Draghi had promised to “do whatever it takes” to support the euro, but he blinked when the Greek banking system needed his help the most. It will likely take years before public confidence in Greek banks can be restored. Indeed, Cyprus, which imposed a two-week holiday on its banking system in 2013, is only now starting to recover.

Ironically, by nearly destroying the Greek banking system, the ECB and other Greece creditors reduced the chance they will be paid back. Constraints on credit availability and an impaired payment system will weigh on Greek economic recovery which, in turn, will make it difficult for the country to produce sufficient tax revenue to recompense its creditors.

But this is certainly not the first time politicians have succumbed to populist outrage over the need to “get tough” with “dead beat” borrowers, by imposing repayment terms that are more punitive than palliative.

We saw a similar self-defeating phenomenon in the US during our country’s subprime mortgage crisis. In the face of political pressure, mortgage modification programmes under both the Bush and Obama administrations retrenched to modest debt relief for subprime mortgage borrowers, combined with onerous and unrealistic documentation requirements, all in the name of making sure “deadbeats” didn’t get a break.

By failing to attack our country’s economic problems at its core – a huge overhang of unaffordable mortgage debt – it has taken years for our housing market to recover. Indeed, in many lower income, urban neighbourhoods, home prices continue to decline, eight long years after the financial crisis.

Regrettably, in dealing with Greece, Europe is repeating, instead of learning from our mistakes, by catering to misguided populist anger and withholding the radical debt relief measures Greece needs to get back on its feet. Indeed, instead of supporting recovery, most of the new bailout money will have to be used to pay back existing debt.

Optimists claim that tools are available to revive the Greek banking system. They predict private capital will be available to recapitalise the sector, that deposits will eventually return, and that Greek banks can be further strengthened by the creation of a “bad bank” that can assume their troubled assets, freeing up their balance sheets so that they can lend again.

But without a single deposit guarantee mechanism, why would Greek depositors trust their hard-earned cash to any Greek banking institution Germany, in particular, needs to understand that true banking union means shared responsibility.

The strong subsidise the weak. Shared responsibility among all US insured banks has been key to the FDIC’s success.

And consider this: if prior to the crisis, German banks had been on the hook for Greek banking losses through a shared deposit insurance scheme, perhaps they would have been a little less willing to facilitate that country’s massive pileup of debt obligations which caused the crisis to begin with.

Greece will never dig out of its problems so long as it labours under an unsustainable debt burden. It will never recover if it is chained to a banking system which lacks credible government backing and confronts continuing credit losses because of poor economic conditions.

Like Sisyphus, it will keep rolling its boulder of debt up an endless hill, only to have it roll back over and over again. Only with true banking union – including a single deposit guarantee mechanism and unequivocal backing from the ECB – will Greece escape the destiny of the ancient Corinthian king.

Sheila Bair will be speaking at the International Association of Deposit Insurers (IADI) Annual Conference hosted by Perbadanan Insurans Deposit Malaysia (PIDM), in Kuala Lumpur this month. Bair served as chairman of the Federal Deposit Insurance Corp (FDIC), one of the US’s principal bank regulators, from June 2006 through July 2011. As FDIC chairman, she presided over a tumultuous period in the US’ financial sector, working to bolster public confidence and system stability.

PIDM, the national deposit insurer, is a member of IADI, a standards-setting body established to promote cooperation and networks among deposit insurers around the world and help countries design and operate efficient deposit insurance systems towards promoting stability in financial systems.