Monday, February 6, 2012

Quote of the Week from p.152 of Raghuram Rajan’s 2010 book, Fault Lines: How Hidden Fractures Still Threaten the World Economy:

“If banks have an incentive to take risk, they will always look for opportunities to get the greatest bang for the regulatory buck. But the regulatory mistake of requiring too little capital for certain activities is then compounded because in taking advantage of regulatory mistakes, banks build up exposure to the same risks. The dynamic associated with systemic risk exposures then kicks in: if everyone is exposed to the same risk in a big way, the authorities have no option but to intervene to support banks and the market if the risk materializes—in which case a bank maximizes profits by increasing exposure to the risk.”

In Rajan’s book the above statement was largely referring to the mass accumulation of mortgage related debt by all the large US banks. The concept may however be prescient when considering the actions of European banks purchasing large quantities of sovereign debt. Based on current market prices for sovereign and mortgage debt, many large European banks are likely insolvent. Thanks to lax accounting requirements and massive balance sheet expansion by the ECB (and other Eurozone central banks), these banks have been able to continue operating. Unless the European economy picks up dramatically across the board, the only chance to return to solvency is through earning substantial profits.

Faced with this troublesome predicament, the best option for European banks may be to vastly increase risk by loading up on European sovereign debt. Private investors in Greek and Portuguese debt will almost certainly face write-downs, however greater effort is being made to ensure Italy and Spain’s creditors are bailed out. By investing in shorter-term Spanish and Italian debt, banks have the potential for sizable profits if the bailout mechanisms are successful for at least a couple years. Even if these profits fail to return the banks to solvency, the returns can be used to continue paying large bonuses over the coming years. If these bets on sovereign debt fail, but enough troubled banks are playing the game, the ECB and EU will almost certainly be pressured to bailout the banks. Although risk may appear to be subsiding, systemic risk may actually be building in the background.

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