A big unknown in the UK referendum debate is the impact this will have on the City of London as the financial capital for Europe. There are three reasons that impact could be negative. The UK referendum debate and European reform negotiations are going to lessen British influence in the design of Europe’s capital union; they are going to eliminate any incentive for Britain to sign up to Europe’s banking union; and they raise the spectre that the UK government will find itself outside of future decisions about the shape of European financial regulation (and perhaps even without the support of the European Court of Justice inside the internal market).
Category / Weekly note
‘Reasonableness’ and the Link Between Government Default and Euro Exit for Greece
Last week my SAIS colleague Filippo Taddei gave an interview to a Bloomberg journalist about the Greek crisis where he argued that there is no necessary link between a Greek government default and the exit of Greece from the euro area. The reason, Taddei explained, is that a government default is only relevant to Greece’s euro membership insofar as such a default would wipe out many of the assets — and essentially all of the collateral — of the Greek banking system. If that were to happen, then the Greek central bank would have no choice but to give loans to the country’s commercial banks against little or no collateral in order to maintain the liquidity of the Greek financial system. Moreover, everyone is aware of this fact. You only have to look at what happened during the second Greek bailout in March 2012 to see the connection. Hence it is only reasonable to assume that the European Central Bank (ECB) would either accept the extraordinary measures of the Bank of Greece to keep the Greek banking system afloat or come up with some arrangement of its own to restock the collateral of the Greek banking system and restore its liquidity during the process of resolving the Greek government’s default. Indeed, Taddei suggested, people active in European economic policy circles are already planning along those lines.
Market Pricing Greece
One of my students asked me why we should worry about a Greek default or exit from the euro when the markets can already factor those risks into the price of any assets likely to be affected in the markets. This is the same question that Gillian Tett highlights in her column in the FT last Friday. Tett’s answer is that there are always institutional quirks in the markets that are hard to factor into different prices. That answer should send investors – and their lawyers – to look through the fine print of marketable assets to find arbitrage opportunities that have not yet been exploited.
They shouldn’t bother. They may well find something worth exploiting but that won’t make it easier to price in the risks around Greece. The reason market participants fail to price such risks efficiently has less to do with the completeness of their models than with the fact that many if not most of them are going to switch from one set of models to another in the event of a Greek default. It is this model switching – and not the discovery of new information – that will roil the markets. Moreover, no-one can predict just how big of an impact this model switching will have on prices. I suspect it will be large.
Erik Jones 