Too Big to Fail: Now, the European Version

TCW Asset Management

Komal S. Sri-Kumar

March 5, 2010

Over the weekend, Greece moved closer toward getting a bailout from the major European powers.  A program may be in place later this week with EUR 20 – 30 billion of a new Greek bond issue purchased or guaranteed by state-owned institutions such as the German development bank, KfW.  The rescue comes despite Article 122 of the Lisbon Treaty, which states that the European Council may financially help a member state only if its difficulties are due to natural causes or “exceptional occurrences beyond its control” – conditions clearly not met in the Greece crisis. The pressure for a financial rescue package appears to have stemmed from demands from major European banks despite the bailout’s unpopularity with voters in Germany, the region’s major economic power.  While such a rescue may have the immediate impact of saving the Eurozone from a new crisis in the face of poor market demand for a planned Greek bond issue of about EUR 20 billion, Europe’s leaders should carefully review how using resources to save financial institutions fared on the other side of the Atlantic.

The United States tried - - both in the final months of the Bush administration and in the first several months of the Obama administration - - to resolve the financial crisis by pouring taxpayer funds into large troubled financial institutions rather than nationalize them and subsequently sell pieces in the open market.  Such a solution could have been used both to restart bank lending, and to break up institutions deemed “too large to fail” so that they would have less ability to bring down the entire economic structure.  As a result, while the stockholders in those financial institutions (“Wall Street”) were saved from a total wipeout, the overall economy (“Main Street”) languished as the unemployment rate surged and bank lending to small- and medium-sized institutions remains anemic.  Furthermore, risk undertaken by the financial institutions has probably increased as there have been no regulatory reforms, and since proprietary trading rather than commercial bank lending has brought the bulk of the profits.  “Too Big to Fail” is still the governing precept in the United States!

In the Eurozone, even though coming to Greece’s aid appears to be the quick solution, it will likely resolve little in the longer run.  The overall debt burden will have to be reduced both in the European public and private sectors, which will probably be achieved through some combination of inflation and debt-related “haircuts” - - both of which would imply losses to debt-holders.  To transfer taxpayer resources from Germany or France now in an attempt to bail Greece out will only increase the country’s debt load, further increase Greek workers’ resentment at the austerity measures, and yet not produce an economic normalization or growth that the Eurozone badly needs.  Rather than choose the seemingly easy way out, German and French governments, the Eurozone leaders, should consider steps that would eventually leave member nations with a stronger single currency area, as well as provide the best prospects for future economic growth.

 (c) TCW

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