Hugo Dixon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

LONDON — Running out of cash — rather than insolvency — is what causes financial crises such as the euro zone’s. Yet the lion’s share of the effort by policy makers around the globe has been to shore up solvency not funding. Unless that changes, the world will lurch from crisis to bailout and back again.

Ireland’s bank crisis is only the latest example of how seemingly solvent institutions can be brought to the brink because they can’t fund themselves. It was only four months ago that Allied Irish Banks (AIB) and Bank of Ireland were given a clean bill of health in the European Union’s official stress tests. One weakness of these tests was that they only stressed solvency not liquidity, although that may be remedied next year.

Ireland’s banks didn’t have a large enough base of retail deposits. AIB’s and BoI’s loan-to-deposit ratios are just above 160 percent. That made them excessively dependent on wholesale money. When that dried up, they had to turn to the European Central Bank. When deposits from corporate customers also started to flee, emergency action was required.

Sadly, this is an all-too-familiar story. Funding was the Achilles’ heel of banks that went to the brink in 2008. The likes of Lehman Brothers, Northern Rock, Washington Mutual, Royal Bank of Scotland and Fortis may have had inadequate equity. But death through insolvency is a slow one. Death, or near-death, through lack of liquidity is a rapid one.

If Portugal’s banks also get sucked into the maelstrom, funding again will be the trigger. Banco Espirito Santo and Millennium BCP have high capital ratios; but they also have loan-to-deposit ratios of over 160 percent.

The issue isn’t exactly the same for governments because they don’t fund themselves through deposits. However, they do need to keep on rolling over debt as well as financing new deficits. The more stable their funding sources — typically if their own domestic private sector is flush with cash — the better.

The lack of such stable funding is the reason why the Spanish government is vulnerable. Its debt/GDP ratio is expected to end the year at 63 percent, below the euro zone average. But the country has a current account deficit of 4.4 percent of GDP — meaning it is dependent on attracting large sums of capital each year from abroad. The government’s habit of funding itself with relatively short-term debt — it needs to refinance 149 billion euros next year — puts it even more at the mercy of the markets.

Unstable funding isn’t just the main cause of crises; it also forces bailouts. It’s thought too risky to let a bank (or government) go under because the creditors who get hurt will withdraw their cash from other banks (or governments) with similar funding profiles. That, indeed, was the experience with Lehman. It was also the argument used not to haircut the senior creditors of Ireland’s banks. In a febrile climate, even such relatively small institutions are deemed too big to fail.

Given the danger posed by unstable funding, one would have thought policy-makers would have done something about it. And they have done something: the new Basel III regime addresses the issue (which is better than Basel II, which didn’t even mention it). But no action is required until 2018. Yes, 2018 — that’s not a typo.

Similarly, some governments — notably the UK, France and Germany — are planning to impose higher taxes on banks the more that they rely on short-term hot money. This is an excellent idea, as it would give banks an incentive to secure more stable sources of funding. The snag is that this initiative has been diluted because it won’t be global. A plan for such a levy in America by Barack Obama seems to have been killed off by Congress.

In the meantime, there will be more crises and bailouts. And banks, governments and their creditors will draw the logical conclusion: it pays to be foolish.

Rahm Emanuel, President Barack Obama’s former chief of staff, popularized the motto that one shouldn’t waste a good crisis. But there is a severe risk that this is precisely what the world has been doing by being excessively soft in bailing out banks and countries since Lehman Brothers went bust in 2008.

Bailouts, such as that being negotiated for Ireland, may be needed to prevent a descent into chaos. But the conditions must be tough. Otherwise, the world won’t learn the lessons from the crisis and justice won’t be seen to be done.

Ireland’s original bank bailout in the wake of the Lehman bankruptcy is one of the most egregious cases of excessive softness. Dublin gave a blanket guarantee to its banks’ liabilities, including wholesale funding. A more targeted guarantee focusing on retail deposits would have been far better. Not only would the creditors have been punished; the state itself wouldn’t now need its own bailout.

But it wasn’t just the Irish who were soft. The Americans gave their top banks excessively cheap capital in October 2008. And many euro zone governments helped sweep the problems with their banks under the carpet post-Lehman. Even this summer’s stress tests were a half-hearted affair. One consequence of this softness is that banks in supposedly strong countries like Germany are still too weak to withstand the bankruptcy of a small country like Greece or Ireland. Another is that the world is still stuck with banks that are too big to fail—a problem that the new Basel III banking reforms will only partially remedy.

The excessive softness has also distorted monetary policy. It’s not just that interest rates have been kept at ultra-low levels; liquidity has been sprayed at banks on incredibly attractive terms. Meanwhile, the U.S. Federal Reserve and the Bank of England have taken the extraordinary measure of printing money to boost economic activity.

Extreme circumstances call for extreme measures. But the hot phase of the crisis in most countries has passed—and so should the extreme measures. What is left is a long grind back to prosperity. That’s unfortunate, but there’s no way that the excesses of the bubble years can just be conjured away. Remember that it wasn’t just banks that lived high on the hog. During the boom, many ordinary people—whether in Ireland, Greece, the UK, Spain or America—did too. World leaders, especially Obama, have failed to make adequately clear that sacrifices have to be made across the board.

In Europe, the strongest disciplinarians have been Britain’s David Cameron and Germany’s Angela Merkel. It is fashionable to criticize them. But the brickbats are largely misguided. Cameron is said to have gone in too hard with his austerity. But the UK has gained a lot of kudos with the markets by doing so. Would it really have been sensible for Britain to be soft when Ireland is blowing up on its border? Portugal and possibly Spain are in danger of being sucked into the vortex precisely because their governments have been slow to appreciate the gravity of the situation.

Meanwhile, Merkel has been criticized for being too harsh in setting the terms for Greece’s bailout—and for pushing the idea that, in the future, bondholders should face haircuts when governments are bailed out. The bondholder haircut idea could, admittedly, have been timed better, but it is still exactly the right principle. As for Greece, its feet had to be held to the fire before it would agree to fight corruption and root out decades of mismanagement.

Returning to Ireland, its bailout conditions have yet to be revealed. Another dose of conventional austerity—for example, reducing the minimum wage and welfare benefits—is probably called for. But from the perspective of fairness, the crying need is also to inflict as much pain as legally possible on bank creditors. That would be the right balance of bailout and punishment.

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

LONDON — “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public.” Normally, Adam Smith’s dictum is a good guide to policy. But in the case of UK banks and their bonuses, it isn’t.

Clubbing together to keep bonuses down wouldn’t please competition purists. Depending on how such talks are orchestrated, it may even be illegal. One could imagine peculiarly tin-eared traders taking their employer to court for
unfairly conspiring to keep down their pay.

That said, the government is keen for bonuses to be restrained, so it is looking at whether there really is a problem. It has waived competition law in the past when it believed there was an overriding public interest — notoriously when it approved the takeover of HBOS by Lloyds TSB in the midst of the financial crisis.

The public interest today is to ensure that bankers are not seen to be making hay when the rest of society is suffering from the government’s savage cuts. Even the banking industry itself has an interest in curbing pay, as that might help limit the regulatory and political backlash. The snag is that it is hard for banks to take the initiative on their own, as they fear their best staff will be poached by rivals who do not take the same approach. Hence, the need to collude.

Competition purists might say that such collusion is still a bad idea. If the government thinks bankers are paid too much, it should take direct action to curb pay — for example by imposing another windfall tax on bonuses. But that solution would be even worse. The UK has just about been able to get away with its windfall tax on bonuses on the basis that it was a one-off. A repeat would seriously damage its reputation as a predictable home for financial services. If the banks do manage to make progress on a deal to curb pay, free marketeers should hold their noses and give their assent.