Guaranteed trouble.

Photographer: Oliver Bunic/Bloomberg

Government Promises and the Next Bank Crisis

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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Austria's government recently shed responsibility for 10.2 billion euros ($10.8 billion) of guarantees that the region of Carinthia had given to Hypo Alpe Adria Bank, so it's no surprise such contingent liabilities are coming to be seen as the source of a potential banking crisis.

Governments loved creating these liabilities after the global financial meltdown of 2008. They appeared to cost nothing, while creating real value for banks. As usual, though, it turns out there's no such thing as a free lunch and the cost of such deals is beginning to emerge.

The best description I have read of this post-Lehman Brothers phenomenon comes from none other than Yanis Varoufakis,  the Greek economist who has since become finance minister in that country's radical Syriza-led government. According to Varoufakis: 

Bank X would lend money to… itself. It would do this by issuing a bond which it did not intend to sell. So, why issue such a phantom bond? Why write an IOU and give it to one’s self? The answer is: In order to hand this phantom bond over to the European Central Bank as collateral in exchange for a cash loan. Normally, of course, the ECB would never accept such a phantom bond as collateral. Accepting it would have been to accept a loan it gave to Bank X as collateral for the said loan. It would have been an assault on the meaning of collateral and a gross violation of the ECB’s rulebook. So, bank X, knowing this, took its phantom bond first to the Greek government and had it guarantee it. With the government’s guarantee stamped on it, the ECB then accepted Bank X’s phantom bond and handed over the cash. Why? Because the Greek taxpayer had, in the meantime, unknowingly provided the collateral for Bank X’s loan.

The "stamp," according to a study commissioned by the European Union in 2011, shaved about 30 basis points off the yields on bank bonds once issued to real creditors on the open market. So governments were creating money with a stroke of a pen. In Europe, central and local governments alike made the most of their ability to do so, because there was no immediate downside: contingent liabilities weren't counted as part of public debt, or even reported to the public in a systematic way.

Varoufakis worried that taxpayers were never asked about such invisible bailouts taking place throughout Europe, an issue of transparency and democratic accountability. The governments' ability to cover the guarantees is, however, probably a bigger issue for financial stability. This ability cannot even be properly assessed now.

Last month, the EU's statistics agency Eurostat made public its first ever release on European governments' contingent liabilities, setting their total amount at 1.28 trillion euros. A lot of that money is the debt of government-owned companies and banks, which is a separate issue from guarantees and, right now, less of a danger. For example, deposits in German government-controlled banks are included in the total, and these aren't really a burden on the German government. The part of the disclosure that deals with guarantees is more worrying. 

The data are only for 2013, and notes at the bottom show they are woefully underreported. For Greece and Ireland, for example, there is no information on guarantees issued to public corporations by regional governments. France, Slovenia and Finland submitted no information at all on guarantees issued by regional governments. That means these countries either do not have, or are unwilling to share, information on the financial doings of their own Carinthias.

Even incomplete, the data are alarming. With government guarantees (not counting deposit insurance schemes)  added in, Austria's debt burden would increase to 109.5 percent of gross domestic product from 74.5 percent; Finland's to 83.3 percent from 59.3 percent; and Germany's to 96.1 percent  from 76.9 percent. In other words, the euro area's most fiscally responsible governments would find themselves with debt-to-gross domestic product ratios on a par with those on the profligate European periphery. 

Outside the euro area, these guarantees wouldn't present as great a problem. In the worst case scenario, countries not subject to the constraints of monetary union could print money to cover their guarantees. Euro zone members are deprived of that ability. They are especially vulnerable to what Imperial College Business School professor Franklin Allen and his co-authors described in a recent paper as a "feedback loop between governments and banks":

When the government has limited resources, the extension of the support that the government offers to banks tightens the government’s budget. This, in turn, affects the effectiveness of the guarantees since, as the situation of the government deteriorates, the beneficiaries of the guarantees start to wonder about the ability of the government to honour its promises. Thus, the credibility of the guarantees decreases and they are no longer effective in preventing crises. As a consequence, the instability in the financial sector further increases, thus magnifying the costs of the intervention.

This could happen in any country where one or two banks that benefited from government guarantees were suddenly revealed to have been too risk-prone, as Hypo Alpe Adria was. Various studies, both European and U.S.-based, have shown that banks that benefit from government aid, such as guarantees, tend to make riskier loans and invest more adventurously than financial institutions that are denied such help. That means the Austrian bank is unlikely to be the last one to collapse and strain a government's ability to cover its obligations.

The Austrian case is already causing a reassessment of the value of European government guarantees. Another such bank collapse could cause a continent-wide panic. Europe must work out a mechanism for properly recording all the guarantees that are issued and establish national and regional ceilings for this type of liability, as well as an emergency mechanism for occasions when a government is unable to cover its obligations. And that might include recourse to the ECB, as a last-ditch savior.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor on this story:
Marc Champion at mchampion7@bloomberg.net