Interview: Professor Udo Steffens of the Frankfurt School

By Zhang Feifei, Paul Pennay
Published: 2010-08-23

EO: What do you think about the stress tests? What do you think will be the market reactions?

Professor Udo Steffens: I think that at the end of the day it will create more transparency in terms of the shock absorbency of individual banks and help paint a picture of the real stability of the financial system. Even if the banking industry is reluctant to publish the results, they have an effect on their refinancing capacity, which is hampered. If a bank were to issue bonds today, it will be difficult to find a new market.

EO: If Spain fails the test, will they be able to draw upon the EFSF, a 750 million Euro fund?

US: They will. If they have to pay higher market premiums for their refinancing then they can refinance their projects with this special purpose vehicle; otherwise they will have to pay 8 to 9% percent as far as the market is concerned.

EO: On the health of the interbank market in Europe, people we've been talking to in Spain and Portugal are saying that the market is no longer working, that banks don’t trust each other enough to lend to each other and they are turning to the ECB.

US: We hear from practitioners and the financial community that this is still the case. After the financial crisis, the market came back a little, but rumors are still spreading around that treasuries prefer to use the ECB facilities and overnight facilities instead of risking the inter-banking market, hampering dynamic growth. But we have seen the new results from the Bank of America and we will see results in the second quarter with overwhelming profits from the maturity transformation. Because the cheap money is still around and this is finally feeding the financial industry - Banking should be easy in principal!

EO: Could you explain to me the banking process? How is banking easy?

US: You lend money against different papers for one percent and invest it immediately in first class treasury bills, which still have a return of 2/3%. This way, you have a risk free margin and this is printing money for the banks. If you do additional engineering and structuring, you will earn a lot of money. We have seen in 2009, bigger and smaller banks who have more or less handled their risk portfolio well have had extraordinary financial results. Our so called, "saving banks" and our smaller banks had the best financial results in three decades during the financial crisis. The broader public does not understand, but it is due to the liquidity and cheap money policy of the European central banks.

EO: And what's the thinking behind the policy?

US: The G20 and also the G8 understand that the finance industry is and will be an innovative industry, like infrastructure. It is like streets and bridges. If you don't have this in an appropriate shape, you cannot compete the globally with the old economies, like India, China and the so-called second world countries. The financial infrastructure has to be in a good shape. That's why they create more money and liquidity, lending is cheap and has a positive effect on the real economy and industry with appropriate risk management. This is the overall scenario. Behind all this we have the fierce competition between the Anglo-Saxon system – using capital markets and a more bank based business model as far as continental Europe is concerned, with the main players being France and Germany.

EO: What would be the consequences of letting the financial infrastructure fail? What if they cut off the liquidity and did not let the banks make easy profits?

US: The central banks are feeding of filling the money into a circle which is normally regulated by the inter-banking market. Via the European central bank the default event risk is eliminated. But an excess of money may accelerate inflation risks and things like that. There is an overwhelming influence of the public sphere in the capital markets. It will be the art of policy makers in order to withdraw the liquidity without causing inflation and other consequences.

EO: Will a successful a stress test put an end to any worries about states defaulting? Will it be a turning point?

US: I don't know. It will help to restore trust and confidence. It contributes to transparency in the mechanisms for market participants even if banking associations think it’s bullshit. The governments are responsible for the framework of the finance industry and in this they have fulfilled their duties. We will see what happens.

EO: With all the worries on the market do you think the market will buy the results of the stress test? Has the government rig the standards with the results already in mind?

US: I think yes and no. They direct it to help most banks pass, so the scenarios are favorable. But no one knows what will happen in real life. Remember the last crisis; nobody was prepared to handle it. But it will give hints to banks as to how to structure their assets and how to manage refinancing, and will give push for higher equity requirements, which will slow down the overall process and shorten leverages.

EO: How did you interpret the ECBC's decision to start purchasing bonds?

US: It depends on your political position; the majority of researchers are saying this is not in the tradition of the Deutsche Bundesbank and not in the tradition of a neutral national bank or a European central bank. Germans are concerned about this decision and its results. We think policies via the market would be more appropriate measures. Rumors say they have invested now 50-60 billion and the majority of those bonds are coming from Greece. We are concerned that the neutrality of the central bank is lost. Let’s see if they return to being a European neutral central bank. In the tradition of the southern countries it is more accepted. At the end of the day it is printing money.

EO: Everyone has been focused on Greek and Spanish banks, but what role does Eastern Europe and Eastern European financial markets fit into what is happening?

US: South and Eastern Europe were regions of hope where a lot of the Western European banks were heavily invested. We have seen an explosion of spreads. People had to pay a premium immediately on their refinancing capacity and the CDS exploded as far as Croatia, Serbia, Macedonia, and Ukraine are concerned. But recent research by one of our professors, says these banking communities are heavily influenced either by Italy or Austria, or sometimes by Germany. Up to 70% of their financial assets were under the control of non-national banks. Bigger banks like Unicredit pumped money into their affiliated banks in Ukraine Serbia, in order to protect their investments. The volumes were feasible and refinancing was easy because these are small communities. A non-national banking community stabilized the banking community. This is interesting because it is against national feeling to have a banking community dominated (70-80%) by Western European banks. Investments and the banking community are still under stress because the currencies of those countries are still under pressure. No one wants to invest in eastern Europe. But they seem to be more or less stable.

EO: About coming out of these emergency measures, if growth does start to pick up and the monetary union and the ECB does decide to lift benchmark rates. What conditions need to be met in order for this to happen?

US: I think the measures will continue for 9-12 months because they need cheap money for refinancing in order to promote growth, which is picking up especially in Germany because it is export oriented (and this has to do with the China situation). Productivity and efficiency in Germany has been raised. Germany will outperform other members of the European community, which creates tension. It has some parallels with China's model. I think in order to promote growth the policy of cheap money will continue for a while, but if the ECB is wise, they will start to limit liquidity. Finally, we don't know if the growth will be robust. The overall question is how will nations in the European community, developed countries, compete with second world countries in the global market? Former privileges they have had in terms of the construction of the global economy is concerned may be challenged. There is pressure from globalization and this may result in the dismantling of free trade in order to protect the society. If you are a PM and you see that your country can't perform you may impose higher tariffs and barriers. Global welfare may be finally challenged. I think this is the bigger picture.

China, Indonesia, Philippines and other second world countries want to be a part of the global economy; they want to have a fair share of the wallet.

EO: This competition will take place in terms of tradable goods and market share?

US: Services, free frontiers things like that, with second world countries copying the model of the EU here and there. There may be pressure on policy makers to have higher customs and so-called non-tariff barriers. It's a very historical, globally difficult situation. The global patterns of policy making are a dynamic process and are challenging historic patterns of how the world runs.

EO: You mentioned that particular countries may want to limit free trade. What is the likelihood that Europe makes this decision as a unified entity?

US: Greece has been rescued by solidarity. After the crisis, if the situation is a little bit more stable there will be a big debate about the future of the European Union because of the enlargement policies. We will reconsider the role of the common currency and the harmonization of fiscal policy and economic models. This will be a conflicting process because different models will compete, and we don’t know how they will compare. Finally we know that Germany sacrificed the Deutschemark on the altar of unification. The Germans have in their DNA an anti inflation policy. A government that does not respect the pattern of small or no inflation will not be reelected. So there will be a strong push into policy on respecting the value of the money. This will be a conflict between France and the Germany and will lead the way for the future architecture of the European Union.

The Frankfurt School of Finance and Management is a research business school. They do a lot of teaching and research in the finance area. For more information about the Frankfurt School of Finance and Management, you can visit their website here.

The above interview was conducted as part of a series of interviews with various officials, scholars and journalists throughout Europe on the topic of the future of the European economy in the wake of the sovereign-debt crisis. The interview was conducted by phone on July 16, 2010.

You can find a collection of the interviews in English here and in Chinese here.