Who can be trusted these days? The media? The government? The central banks?
Trust in all three is waning, if not outright broken in the eyes of some. Which poses a big problem to us as investors for our entire financial system is built on trust, or the financial form of trust known as credit.
When that trust breaks down between the banks, the entire system seizes up. It’s for this reason the global financial crisis was originally given a more accurate name: the credit crisis. In 2008, financial institutions no longer trusted each other, and the flow of credit (loans) between them which kept them solvent slowed to a halt.
Many years ago, banks practised asset management, taking in deposits before making loans to earn interest. But today, liability management is the name of the game: banks promise loans to their customers first, before borrowing the funds necessary from other banks.
A more profitable strategy to be sure – the quantity of loans a bank can make is no longer constrained by the amount of deposits they have. But a riskier strategy too – and one ever more reliant on trust.
Blind trust
This trust dynamic has a twist in Europe, where banks are mandated by law to trust all European governments equally.
Investors can reflect their trust and distrust in different governments by demanding a higher or lower rate of interest when they lend them money. Germany, trusted highly, pays low (or even no) interest. Greece, trusted less, pays higher interest.
But under EU law, loans banks make to European governments are rated as “zero risk”. While eurozone governments may charge different taxes, blow money on different pet projects, not to mention their varying levels of competency, EU law (Capital Requirements Directive (2013/36) to be precise) dictates that all eurozone government debt is equally trustworthy.
The implications of this are vast and grave. For if all government debt is viewed as equally trustworthy, banks are incentivised to lend to the government that will pay the highest interest – ie, the governments that investors view as the least trustworthy.
It’s for this reason that while investors were throwing Italian debt out the window, European banks have been picking it up by the billion. It pays higher interest, and the law says it can be no riskier than German debt. (For Italian banks, it also buys favours with the government.)
But the passing of Capital Requirements Directive 2013/36 did not alter economic reality. Instead, it mandated that critically important components of the financial system be blind to risk.
Germany is not Greece. Italy is not Ireland. They are not all as creditworthy as each other. Their debt is not all “zero risk”. Hell, no government debt is “zero risk”.
Risk cannot be legislated out of existence, just as trust cannot be legislated into existence. Risk cannot be destroyed, only transferred.
The EU no doubt thought the CRD would create financial stability. Historians may well summarise their efforts (at this time of year at least) with the reflection of the great bard Robert Burns: “The best laid schemes o’ mice an’ men, Gang aft agley.”
Until next time,
Boaz Shoshan
Editor, Capital & Conflict
Category: The End of Europe