Luxembourg’s lead central banker puts Europe’s banks on notice

Yves Mersch, governor of the Banque centrale du Luxembourg and member of the European Central Bank council today warned Europe’s banks they would not be rescued a second time.

Markets are watching Mersch’s speech ( [asset_library_tag 2823,Yves Mersch Berlin speech] ) closely this afternoon to gauge how a leading candidate touted to replace Jean-Claude Trichet as the European Central Bank’s president views financial institutions.

Speaking at Berlin’s Freie University, Mersch backed financial regulation to avert future crisis but not to be an “overly tight corset which leads to strangulation of market dynamics”.

He said the maxim some banks were ‘too big to fail’ is “not compatible with the principles of a market economy”, and moral hazard from bail-outs means “the State and its taxpayers are held to ransom.

“The moral hazard can lead to institutions becoming too large to be rescued by the State. Those who collapse in the market must be liable, even to the ultimate consequence of leaving the market.

“Exaggerated faith in the State, just like faith in an out-of-hand public sector, leads sooner or later to lack of freedom or bondage.”

However, he added the State had an important role to play in financial regulation.

“The idea that financial markets can be self-regulating was painfully refuted during the crisis.

“The financial crisis showed that regulation and regulatory authorities globally did not offer sufficient protection. A need for root-and-branch reform has become apparent. The goal must be to protect the international financial system from such similarly devastating events in future.

“It is about finding a balance between the market and State, the measured rules which the State sets, so that the freedom of markets can generate as much possible lasting wealth and benefit.”

Mersch said stabilization measures already enacted had bought debtors time, but this must be used to improve financial and political frameworks in Europe.

He also signalled agreement with precepts behind Brussels’ bid to control hedge funds – manifested in the Alternative Investment Fund Managers’ directive, and subsequent curbs on short selling.

“Hedge funds attack crippled financial institutions with short selling, in order to wound or take down unwanted competition.

“The market values of the affected institutions can come under so much pressure through such comprehensive short selling that, without fundamental justification, they finally disappear from the market.

“Rules must be found for the shadow banking system for private equity and hedge funds. These institutes are not banks in a legal sense, but they take similar risks.”

He said a “strict silo-like regulation of the formal banking world” missed the danger that “hazardous businesses do not disappear, instead they simply migrate into the unregulated arena”.

Mersch also dismissed critics of the euro project: “The single currency is stable and successful. The inflation rate in the eurozone averaged 1.97% in the first 12 years. The euro has firmly established itself also as the second most important reserve currency after the US dollar.”

Much research has been done on what caused the crisis, but Mersch said economic scientists “have two generations of research projects ahead of them”.

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