All of this matters because if a government stands behinds its banks, those banks need much less capital in order to be viable.  Capital is a buffer against losses – it represents the shareholders’ wealth and as such “absorbs” the damage caused by bad loans or disastrous purchases of securities.  If a bank’s capital falls to zero (or below), it is out of business – unless it can raise new capital, which would typically be hard to do from private markets for a failed bank.

But if the state stands behinds its banks, it will be more willing to “inject” capital as needed.  Government officials may not want to do this as a matter of routine – primarily because that would worsen the moral hazard problems of the banks’ management, i.e., they would have no incentive to be careful.  It could also be politically unpopular to provide too much support in this fashion.

Still, there is no question that while we wait for the public results of the European bank stress tests, the relevant governments are making it quite plain that their big banks will not be allowed to fail.  We shall see if this commitment comes with more effective corporate governance and personnel changes than was the case in the United States – when the top 13 Bankers (and almost everyone else in leading financial institutions) were bailed out unconditionally.

In any case, the global competitive landscape is changing unambiguously.  Despite all the obvious incentive problems in the eurozone writ large (including irresponsible lending at many levels), the state is not retreating from banking in Europe – on the contrary, it is becoming more deeply committed.


And onto the global scene now burst the Chinese banks, loved by the markets and backed by the state  (as seen in this week’s IPO by the Agricultural Bank of China).

With the European and Chinese states on course to back their global banks for the indefinite future, this traditional approach increasingly seems unappealing.  Either we will play in the same state-backed banking space (and face the dangerous consequences) or we will need to think about the international basis for trade in financial services from a new perspective.

A new perspective like kickin’ the State out of banking for example?

Because there are only two ways, you see.

You can increase the involvement of the State. Already tried, it fails.

Or we can reduce the involvement of the State. Like really reducing it. Like, less control, no more too big too fail, no more privatization of profits and collectivization of losses, like no more taxpayers’ money and debt to the rescue. Like a more open banking sector, like more competition in it. Like no more big banks’ corporatism. Like free markets. Like no more easy money from the Central Bank to the big banks, meaning less power for the State. Like, voting for libertarians to achieve that. Oops, I think I reached the cognitive limits of The Baseline Scenario.

Touching, I said.

Source: The Baseline Scenario

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