Limiting ‘too big to fail’ banks

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The future of the eurozone is looking gloomy. The recent interest cut has put the region into the same situation as Japan and the US: a developed economy with a deflation problem.

A near-zero rate of interest is never considered good in economic terms. When interest rates are cut, it means the country concerned is struggling to cope with underconsumption.

This can be seen in the case of Japan, which has been struggling with decades of recession after the bubble exploded in the 1990s. The US also became a victim after the 2008 mortgage crisis. The eurozone is apparently the next one in line to join the club.

The gloomy scenario in the eurozone contrasts with the economies of developing countries. In January, Moody’s upgraded Indonesia’s rating to investment grade following Fitch who had upgraded the country’s rating in December 2011. Indonesia had finally regained the investment rating it lost during 1997 financial crisis.

In contrast, several eurozone countries (Belgium, Cyprus, Italy, Slovenia and Spain) had been downgraded by Fitch by Jan. 27, 2012. This was followed by another Moody’s downgrade of the world’s largest bank in June. The eurozone downgrade will influence the capital inflow to Indonesia, albeit not significantly, as these countries are still categorized in investment rating.

The investment grade adds another problem: Indonesia’s sovereign debt has increased by an average of 7 percent since 2007. Despite the declining debt-to-GDP (Gross Domestic Product) ratio, the nominal amount is increasing.

While debt is necessary to finance a budget deficit and boost development, it is meaningless if it is corrupted. The budget mark-up scandals occurring in the House of Representatives is a sign that the state budget and debt are easily misused due to a lack of transparency and responsibility.

This trend is not to be treated lightly. Debt is the reason why the US, the European Union (EU) and Japan — comprising the three largest economies in the world — are facing recession. Many African countries are facing underdevelopment because aid and debt are constantly corrupted by money-hungry officials.

Debt is a time bomb if not utilized properly. Some bonds have a maturity date as far away as 2042, which will burden the financing power of future administrations.

Once debt exceeds a level that the government can capably handle, recession is inevitable because the government must prioritize their obligatory payments.

The government may also face problems, such as the cut in subsidies, which will increase inflation and reduce the public’s overall purchasing power. A vicious circle might therefore occur with the government having to create more debt to pay off its previous debt, making it unproductive.

The combination of the investment-grade upgrade and the eurozone crisis is not yet a blessing in disguise. On the contrary, the flow of hot money from foreign investors will increase stock performances as well as making it vulnerable.

The reason why the eurozone crisis is much more serious than the financial crisis in the US is due to the size of its banking industry, which equals or exceeds each country’s GDP, exemplified in France and Belgium.

The high ratio of banking assets to GDP means European banks are rooted too deeply in the system, increasing systematic risk. They become too big to fail and will always be bailed out when facing liquidity crises. Greece is dwarfed in comparison to the biggest European economies, such as Germany and France.

However, the European banks have invested their money in Greek bonds, and when these bonds start to default, they will affect bank liquidity, and in a worst-case scenario lead to insolvency.

Many lessons can be learned from the US’ and eurozone crises. They teach the monetery regulator that crises mostly occur due to self-fulfilling prophecies. When people panicked and withdrew their money from banks, a liquidity crisis occurred; the banks then asked officials to bail them out, increasing negative exposure, and triggering a vicious circle.

It is also necessary to oversee a bank’s assets, preventing them from becoming too big to fail. There should be regulations to supervise a bank’s assets to prevent systematic risk in Indonesia’s banking system. There should also be stricter supervision when banks’ assets have reached a certain ratio to the country’s GDP.

The fall of financial giants in developed countries has taught the world that banking assets do not mean anything, because the so-called “asset” consists of debt. History has taught us that once those debts turn into toxic assets, a bank is technically waiting to be bailed out, which will cost public money and spread the financial crisis into the market.

The writer is a researcher from Royston Advisory. The views expressed in this article are his own.