Too big to rescue

This post from February 2009 has an update at the bottom from June 2010.

After Iceland collapsed and went into Depression, there were a number of analyses in the press regarding countries with outsized financial sectors. The worry was that the collapse of Iceland was not an isolated incident, but rather a harbinger of things to come for smaller countries with large financial sectors. I wrote a post in November called "Iceland: a cautionary tale for small nations" which pointed to a number of countries that I considered vulnerable including Austria, Denmark, Ireland, Sweden and Switzerland. Even the United Kingdom has been a concern.

Those worries are still with us three months later. And with good reason as many countries in Eastern Europe are in or headed for Depression, Latvia being the most obvious example. (Many of the aforementioned economies have banks with large exposure to Eastern Europe).

Here is the crux of the matter: there are a number of banks, which are very large in relation to the size of their domestic economy. In the past, that has meant that they are too big to fail. Citigroup is a prime example of banks that fall into this category.

But, there are also a number of banks with an asset base that is disproportionately large mainly due to many overseas assets. I have pointed to Royal Bank of Scotland as a prime example. What this means is that the governments where these banks are domiciled cannot make credible guarantees regarding the institutions in question.

If we suffer a crisis of confidence and these banks come under attack, they become literally too big to rescue.

To give you a few numbers, I will give you some examples in no particular order.

• Denmark – GDP: $312 billion; Danske Bank – Assets: $615 billion (197% of GDP)
• United Kingdom – GDP: $2.8 trillion; RBS – Assets: $3.8 trillion or 136% of GDP (with HSBC and Barclays this rises to $8.6 trillion or 226% of GDP)
• Switzerland – GDP: $492 billion; UBS and Credit Suisse – Assets: $3 trillion (658% of GDP)
• France – GDP: $2.6 trillion; BNP Paribas, Agricole, SocGen, and Dexia – Assets ($6.7 trillion or 259% of GDP)
• Netherlands – GDP: $777 billion; ING – Assets: $1.8 trillion or 231% of GDP (with Fortis this rises to $2.9 trillion or 385% of GDP)
• Germany – GDP: $3.3 trillion; Deutsche Bank – Assets: $2.7 trillion (83% of GDP)

This list is far from comprehensive — it does not include Sweden, Ireland or Austria and it does not include other non-bank financial companies like Hypo Real Estate or Allianz. Germany is the best of the bunch, largely due to the size of its economy. But if you add in Commerzbank (incl. Dresdner), Postbank, WestLB, and the Landesbanks of Baden Wuerttemburg and Bavaria, you have a problem there too. And many of these German institutions are already having problems.

The data all comes from Data Monitor and Wikipedia.

The long and short of it is: many countries in Western Europe have weak financial sectors with high systemic risk. The concern here deals mostly with the theory of reflexivity, popularized in finance by George Soros. Wikipedia has a decent definition:

In sociology, reflexivity is an act of self-reference where examination or action ‘bends back on’, refers to, and affects the entity instigating the action or examination. In brief, reflexivity refers to circular relationships between cause and effect. A reflexive relationship is bidirectional; with both the cause and the effect affecting one another in a situation that renders both functions causes and effects. Reflexivity is related to the concept of feedback and positive feedback in particular.

An example is the interaction between beliefs and observations in a marketplace: if traders believe that prices will fall, they will sell – thus driving down prices, whereas if they believe prices will rise, they will buy – thereby driving prices up.

Whilst we have beaten back the panic which surfaced after Lehman Brothers collapsed, there are still nagging doubts about the health of the global financial system. And in a world of reflexivity, it does not take much for these doubts to manifest themselves in self-reinforcing panic and collapse. Paul Krugman says this is the key lesson from the Asian Crisis of 1997-1998 in his book "The Return of Depression Economics."

Looking at today’s crisis, the datapoints I have just provided demand an aggressive policy response in order to eliminate worst-case outcomes. This is, in the main, the problem I have with the policy response to date in Europe and the United States. Hypothetically speaking, if we were to face a crisis where GM credit default swaps are triggered by bankruptcy or where Bank of America collapses, where the Austrian banking system required EU support or UBS faced bankruptcy — in these scenarios, is the present policy response sufficient to deal with the volatility that would result?

My answer is no.

Sources

Reflexivity (social theory) – Wikipedia

Top 25 European Banks – Data Monitor

Benchmark Currency Rates – Bloomberg

Update 2010: I have written a post listing the top banks by asset size in Europe and globally. Generally speaking, the banks above Banco Popular Español in the largest economies too big to fail ($200 billion in assets or more). In the smaller economies like Austria and Greece, you have National Bank of Greece and Raiffeisen International Bank or Volksbank as banks that also fall into that category.