Yves here. The Financial Times and New York Times tonight both have good overviews on the state of play in the effort to contain a slow-motion Spanish bank run. On the one hand, the Spanish government is in a position to tell the Eurocrats that it will consider only a bank bailout and not be required to take on further austerity measures. Given that retail sales have fallen nearly 10% year to year, it’s hard to see how anyone could expect more austerity to be a good idea.
On the other hand, although markets reacted as if a deal was imminent, the FT makes it sound as if quite a few details need to be ironed out. And no wonder: the ECB, the one institution that could act unilaterally, has indicated it will only play a limited role and is leery of making long-term loans to Spanish banks or buying their debt. In addition, Spain appears to be taking an unwise posture, of asking for as little money for its banks as it thinks it will need. Rumors from Spanish officials come in at €40 billion, while European officials are looking at numbers more than twice that large. The big rule of fundraising is always raise a good bit more than you think you need in the first round; it will be vastly more expensive if you need to come to the well later.
Given that the shape of a Spanish bank rescue is very much in play, posts by European experts may well influence the outcome. While some of these recommendations might sound like the banking versions of apple pie and motherhood, it’s important to recognize that few of these basic principles have been adopted in recent bailout programs.
By Daniel Gros, Director of the Centre for European Policy Studies, Brussels, and Dirk Schoenmaker, Dean of the Duisenberg School of Finance and Professor of Finance, Banking and Insurance at the VU University, Amsterdam. Cross posted from VoxEU
In Greece, the problem is an insolvent government bringing down the banks. In Spain, the problem is now insolvent banks bringing down the government. This column argues that despite their differences, the potential costs to the rest of Europe mean that both problems require a European solution.
The diabolic loop between the solvency of the banking system and the sovereign fiscal position is now apparent (Lane 2012).
In Greece, it is the insolvency of the government that has sunk the banks;
In Spain, the banks are sinking the government.
What is common in both countries is that savers are running away when they see the banks and the sovereign propping each other up. Unless the banks in both Greece and Spain are soon recapitalised, the on-going gradual deposit flight might turn quickly into a classic run, the consequences of which are hard to imagine.
We argue that in the case of Spain’s banks, their dire need of capital can only be provided by a European institution, the European Stability Mechanism (ESM). Likewise, given that the Greek government is in no position to prop up its banks, only the ESM can save the Greek banking system. In both cases the ESM, the ECB, and the national central banks should then take control over the banks they have recapitalised, probably best achieved through a new special purpose vehicle (staffed by experts from European Banking Authority).
For the medium term, the creation of a European Deposit Insurance and Resolution Fund (EDIRF) could make the European banking system more resistant to national shocks and the contagion from the Greek and Spanish cases (see our recent research, Schoenmaker and Gros 2012).1 However, the crisis in both Greece and Spain are threatening the survival of the system today and thus require an immediate solution, before the long-run solution can be made operational. The special purpose vehicle used for immediate intervention in Spain and Greece could later be merged into the future EDIRF.
The Commission’s proposals seem again to be a case of ‘too little too late’. The idea of having some co-insurance among national deposit guarantee systems in case a bank with pan-European activities gets into trouble might be useful. But this assumes that there will be any pan-European banking groups left in the Eurozone. The ‘balkanisation’ of the Eurozone’s banking system is progressing now so rapidly that this might soon no longer be the case. Moreover, the problem today comes from local banks, both in Greece and in Spain (where the internationally active banks do not seem to have been heavily involved in real estate lending). In Ireland, the losses came from banks that were mostly local in their activities.
The trouble with troubled banks
Dealing with troubled banks is a difficult topic as every country is a special case. The general theme that emerges in all cases is that a ‘European approach’ is needed when the sovereign is too weak to stand behind its banks. The details vary from case to case. But the general principle is clear: the deeper the hole, the more risk ‘Europe’ will have to take. This is unavoidable given the vital interest of the entire EU in preventing a wholesale collapse of the banking system in any member country. Moreover, the Eurozone taxpayer has already taken large risks given the huge outstanding credits of the ECB towards banks in these countries.
The general principles that should be applied in all cases are simple (see Schoenmaker and Gros 2012 and Allen et al. 2011):
The private sector should be ‘involved’, especially in insolvency cases
Equity holders should be aggressively diluted and debt holders should contribute via haircuts or debt-equity swaps.
The least cost principle should be followed.
This says that the resolution authority should choose the resolution method in which the total amount of the expenditures and (contingent) liabilities incurred is kept to a minimum.
Swift decision-making is essential
.
Procrastination leads only to an accumulation of even higher losses and gives private creditors the time to escape any losses by offloading their claims at the government or the ECB.
Finally, resolution requires a change in governance to align the interest of management with those who bear the risk after resolution, namely the public authorities.
Bearing these principles in mind, we propose the following:
1. Spanish banks are recapitalised only after full loss recognition
The Spanish supervisor has clearly failed to recognise the depth of the bust in the local real estate market. This is not surprising. All real estate bubbles develop under the premise that ‘this time is different’, or rather that ‘this country is different’. The balance sheets of all Spanish banks must be revalued at a ‘bust’ scenario for the real estate sector (meaning a further large fall in house prices and higher loss rates on mortgages given the ongoing recession, see Alcidi and Gros 2012).
The toughest decision is then what amount of private sector involvement should be required. There is of course a national legal framework for this in the case of a formal insolvency, but it is usually not respected because some groups of creditors are politically too important. The decision of the extent of private creditor participation (dilution of present shareholders, holders of subordinate debt up to senior bondholders) should best be taken by the ESM itself because this institution will be able to weigh the benefit from having to inject less capital against the potential for a destabilisation of the Eurozone banking system. (By contrast, in the case of Ireland the national government had to bear all the cost of preventing a potential destabilisation of the Eurozone banking system through a haircut on senior bondholders.)
Once this has been done and the ESM is satisfied that the restructured cajas (Spanish savings banks) are sound, they could be immediately admitted to a European deposit guarantee scheme. A decisive intervention of the ESM should thus be sufficient to re-establish confidence in the Spanish banking system and stem the deposit flight which has already reached alarming proportions.
2. Stem the deposit flight from Greece
Here, the banking system was effectively bankrupted by the sovereign. Greek banks held Greek government bonds equivalent (in nominal value) to over 200% of capital. The Greek banking system thus had to be recapitalised in the context of the Private Sector Initiative (PSI) operation. The most straightforward solution would have been nationalisation (followed by re-privatisation once the adjustment program had succeeded in stabilising the economy). However, everybody agreed that the Greek government would constitute the worst of all possible owners of the banking system of the country (even for an interim period). Given the self-imposed restriction that the EFSF could only lend to the government combined this led to a recapitalisation via preference shares, which implies full risk for the European tax payer without any control.
In reality, the Greek banking system has de facto negative equity if one puts their claims on the government on a mark-to-market basis and factors in the losses on the existing loan portfolio which only increase as the recession deepens. The solution must therefore be similar: the ESM (via its special purpose vehicle) should take over the banking system, wipe out existing shareholders and assume full control.
The key question in the case of Greece is, however, how to stem the on-going deposit flight that is prompted by a fear that the country might be forced to leave the euro. It is of course not possible to extend a European deposit guarantee to Greek depositors because then the incentives for the government would be clear: if it reintroduces the drachma and converts only loans into the new currency the cost will be borne by the European Deposit Insurance Fund.
However, doing nothing means that the trickle of withdrawals could soon turn into a fully-fledged run. The best might be therefore to make the (new) Greek government the following offer. The ESM/EDIRF could provide a partial insurance for retail deposits (say up to 10 % of the maximum) provided the government agrees to implement the adjustment programme (and thus qualifies for further financial support). Each year, the government continues to implement the adjustment programme the ceiling on the guarantee could be increased. But the entire guarantee would be forfeited if the government decided to stop implementation and exit the euro. This combination would immediately create the strong constituency in Greece for a real adjustment that has been missing so far. Until now public sector employees and pensioners had an incentive to vote against ‘austerity’ to protect their income. With this partial and contingent deposit guarantee there would immediately be millions of depositors who might vote differently to protect their savings.
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I get confused about which banks are sovereign and which are private in all the countries of the EU and for that matter all over the world. Please educate me with links and such to this kind of information…..thank you.
There just seem to be way too many factors to control around forming a EU solution to the fringe countries financial problems. The EU is now motivated to develop protection against Shock Doctrine events but will only execute a plan as the result of some countries leaving…to rearrange the chairs, so to speak.
Aren’t we just seeing more sophisticated can kicking here? Where are the jobs? Where are the socio-economic strategies for a stable EU?
The current EU leadership is looking backward instead of forward and until that changes the floggings will continue.
psychohistorian said; “I get confused about which banks are sovereign and which are private in all the countries of the EU and for that matter all over the world. Please educate me with links and such to this kind of information…..thank you.”
The banks are all privately controlled by the <1% — the people don’t own jack sh!t! The divisive, private sector vs government sector meme, is the good cop bad cop bump and grind meme that just keeps on giving. The rubes have swallowed this hook so deeply that it is falling out of their assho!es.
We need the one sector and a measure of GDH, Gross Domestic happiness.
Full disclosure; I am not a “European expert”.
Deception is the strongest political force on the planet.
“. . .Until now public sector employees and pensioners had an incentive to vote against ‘austerity’ to protect their income. With this partial and contingent deposit guarantee there would immediately be millions of depositors who might vote differently to protect their savings. . .”
So, instead of just beating the people of Greece (not just public servants and retirees) with the stick of austerity, we should dangle a carrot in front of them in the form of desposit gaurantees. Then we just continue to beat them with the club of austerity.
So much better. No need to mention the entire banking system the EU is bailing out is the root cause of the problem nor that the same financiers want their mistakes to be paid for by tax payers through austerity policies.
“Quick, the patient has lost four pints of blood. Get out the leeches.””
‘The ESM/EDIRF could provide a partial insurance for retail deposits (say up to 10 % of the maximum) provided the government agrees to implement the adjustment programme … This combination would immediately create the strong constituency in Greece for a real adjustment that has been missing so far.’
You’re gonna guarantee 10% of my deposits (10,000 euros), when Greece already HAS a 100,000-euro deposit insurance scheme?
NICE! If I were Greek, I’d already be booking my ticket to Switzerland.
This proposal is patently insulting. Obviously written by two northern Europeans who view southerners as draft animals that can talk.
Funny, I would say the one thing ALL of the economic calamities seem to have in common is the elite rulers and banksters willingness to make the innocent citizens pay for the bankster’s mistakes.
“mistakes”??
Just let it burn already. Stop devicing “rescue” plans on the back of eurozone citizens. The entire thing is rotten from top to bottom, out of whole cloth. There is nothing to save but corruption. Pour gasoline on the fire already.
Gros and Schoenmaker have an idea to enable the ESM (or some kind of European entity) take over the troubled banks. This supposes that the new owners of the banks will want to. Why would they? Would YOU want to own and run these banks? There is no upside financially and not politically. Why own a busted bank? If you want to close it down, there are better and faster ways to do that.
Their solution is also unworkable for the reason they mentioned: that the political “sensitivity” (aka payoffs to political friends) of the cajas and Greek banks wouldn’t allow foreign control.
There is also no risk of “contagion”. Why would a bankrupt Spanish caja “contage” a French or German bank?
Sorry, don’t buy it. Busted banks should be busted, period. Depositors should be paid their insurance cover and move on.
Dear snowedin;
The limiting factor here seems to be the degree of ‘exposure’ “foreign” banks have to the teetering Spanish and Greek banks. Also questionable are several other European ‘fringe’ countries: Portugal, Hungary, Italy, and yes, Ireland. This problem could soon be “Too Big To Fix.”
The Euro system worked fine as long as countries shared not only a forex rate but also an interest rate. Uniform interest rates assume that sovereigns are de facto if not de jure risk-free. Moreover it does not seem possible to run a banking system without a risk-free asset, and it is hard for banks to turn down their own government for a loan.
The crisis in the eurozone was enabled by an inconsistency between banking regulators and the foundation sovereign treaties concerning the risk weighting of sovereign bonds.
At present the market is assuming Bunds are risk-free. This is false and banking regulations should now establish a risk-weighting on all euro sovereigns to prevent banks from being bullied into buying their own government bonds. At that point ‘risk-free eurobonds’ will suddenly look more attractive and the weaker banks can be helped by exchanging their risky government paper for risk-free paper. This will not save mortgage losses, but the only cure for that is time plus wage inflation.
Also, the banks have been getting into messes for hundreds of years. Could it possibly be that a money system based on usury for stolen purchasing power will always create messes?
Oops! My comment was a general one and not a reply to yours.
Sorry.
I agree with “Glenn” and “they didn’t leave me a choice”.
Look people, LISTEN UP. Its different this time. The Great Depression was just money game crap. This time our economic system is facing REAL limits, both in terms of ecological systemic collapse and resource depletion, of which water is the critical one. You must start linking economic and environmental thinking. These central bank cartels have run out of road and must impose totalitarian rule or dissolve as they no longer have the headroom to facilitate their facade of prosperity for all. Permaciulure now.
Even if we do have resource problems the root cause is still the money system which REQUIRES exponential growth JUST to pay the compound interest and which REQUIRES everyone to borrow or be left behind by those who do borrow.
“The whole nine yards” in a nutshell. Thank you, F. Beard.
Absolutely. “Growth” as currently defined will end in suicidal or genocidal horror beyond anything we’ve ever seen. But I fear it will take a major, though not planetary, eco-system collapse in an “important” part of the world before our ruling elites snap the F out of it.
The problem, of course, at least her in the US, is our corrupt political system whose politicians have written the rules to benefit the bankers. They pay very well, don’cha know? :-)
Best to clean up our own house, and then see if our rules can affect their banks.
Jack Lohman
http://MoneyedPoliticians.net
Until now public sector employees and pensioners had an incentive to vote against ‘austerity’ to protect their income. With this partial and contingent deposit guarantee there would immediately be millions of depositors who might vote differently to protect their savings. Daniel Gros
What’s this austerity pusher doing posting here? Note he puts “austerity” in quotes as if the Greeks are not really suffering from it already?
Also, one of his solutions – nationalize the banks, clean them-up and re-privatise them reeks of fascism as does the European deposit insurance scheme.
However, another of his solutions, “Equity holders should be aggressively diluted.” hints at the ultimate solution to the money problem – money should be equity and not debt.
The comment about the rule of fundraising is off the mark. This is not fundraising, and the rules of this game are very clear for the countries seeking bailouts. The key is to parcel the bad news out in small doses and hide their true problems. The Northern European countries must be presented with a series of perpetual small cuts, where the cost of the next bailout is clearly much less than the cost of letting the market solve the problem. If Spain or Italy fessed up that their problems will require hundreds of billions to fix, the jig would be up.
Starting from a macroeconomic accounting point of view and acknowledging that the sum of financial assets and liabilities is zero, an important question to ask is: who are the owners of financial assets corresponding to all the Eurozone sovereign and banking debt?
Without fresh money from the ECB, ultimately only the relevant creditors – the super-rich and some surplus countries, and their respective financial vehicles – have the capability to refinance the debt of this ‘speculative borrowers’ (Minsky), but not ordinary European citizens.
The European public begins to understand that belt-tightening of the state tanks the economy and doesn’t solve the crisis, but leads to recessions and unemployment. But Eurozone countries are trapped in a nationalistic discourse which continuously plays up arbitrary differences between countries and assigns blame, discussing questions like ‘Who works hardest in Europe?’, ‘Which countries live above their means?’, ‘Will Merkel stay firm against Hollande?’, ‘Will Greece stay in the Eurozone after default, or will it be flushed out before?’
Thereby it is overlooked that so-called rich Eurozone countries are themselves in debt up to their ears, as the relevant financial assets for refinancing are simply not in their hands.
Even English-speaking media in the US and UK are not of much help as they have an easy sell reporting and commenting on differences among Eurozone countries. And not even the most respected public intellectuals speak out clearly on Eurozone inequality as part of global inequality, and – besides financial deregulation – a root cause of the Eurozone banking and sovereign crisis.
One of the
best recent studies addressing global inequality and financial deregulation in context of the current crisis stems from Kingston economist Engelbert Stockhammer, who stands in the tradition of Michal Kalecki. You can find an overview on the studies main line of thought here.
We have to be aware that problems cannot be solved when analysis falls short in such a spectacular way. A breakup of the Eurozone seems to be the logical consequence.
Here is the link to Engelbert Stockhammer’s excellent study “Rising Inequality as a Root Cause of the Present Crisis”.
NB: “a root cause” rather than “the root cause.” A linguistic hedge?
Stockhammer:
“This paper has investigated the question whether rising inequality has contributed to the imbalances that erupted in the present crisis, in other words, whether rising inequality is a cause of the crisis.
We have discussed four channels through which inequality may have contributed. This is not to be understood as an alternative to financial factors, but as a complementary explanation that highlights the interaction of financial and social factors.
First, increasing inequality leads potentially to a stagnation of demand, since lower income groups have higher consumption propensity.
Second, countries developed two alternative strategies to deal with this shortfall of demand. In the Englishspeaking countries (and in Mediterranean countries), a debt-led growth model emerged, in contrast with the export-led growth model in countries such as Germany, Japan or China. These two growth models became feasible because financial liberalisation of international capital flows allowed for
unprecedented international imbalances.
Third, in debt-led countries rising inequality contributed to the growth of debt as the poor have increased their debt levels relative to income faster than the rich. For the USA this can be clearly seen in debt-to-income ratios for different income groups. Financialization has meant debt growth instead of wage growth. This growth model is not sustainable.
Fourth, increasing inequality has increased the propensity to speculate, i.e. it has led to a shift to more risky financial assets. One particular aspect of these developments is that subprime derivatives, the segment where the financial crisis broke out in 2008, were developed to cater to the demands of hedge funds that manage the assets of the superrich.
Increasing inequality has thus played a role in the origin of the imbalances that erupted in the crisis as well as in the demand for the very assets in which the crisis broke out. Our conclusion that increasing inequality, in interaction with financial deregulation, should be seen as root cause of the crisis.”
A trove of trenchant analysis “out of the box” by Steve Keen et al. is delivered at http:ineteconimics.org.
I’ve read that the damage to Goldman Sachs and other US TBTF could be epic, so whatever we can do to allow that to happen would be a painful thing at first, but once we have our own entrenched war profiteering, resource exploiting banksters brought to their knees, there is a chance to rebuild while they wither away into obscolescence along with their outdated crooked casinos.
“In Greece, the problem is an insolvent government bringing down the banks. In Spain, the problem is now insolvent banks bringing down the government.”
That’s interesting. Probably more accurate to say that in Greece, the problem is an insolvent government bringing down French and German banks. Otherwise, the Greeks would have long ago been cut loose
Yes, it’s time to call their bluff. Take your positions.
Yves-
“yveshere.com” domain expires 6/17 and should be available on 6/30 for purchase. I like it for the title of your next book :)
(sorry, do not know how else to contact you)
Yves, Great to hear your voice coming through. While others’ voices are now more prominent on NC, it is your focused and critical voice that I most appreciate.
“This proposal is patently insulting. Obviously written by two northern Europeans who view southerners as draft animals that can talk.”
–Jim Haygood
I love that comment. Whenever I see a “solution” to the European crisis, I pull out my list of the problems which underlie the crisis and see how the solution matches up.
1) Lack of a democratic fiscal and debt union
2) A weak, ineffectual central bank
3) An insolvent, predatory banking sector
4) Europe internal mercantilist trade patterns
5) A corrupt European political class
6) Rich kleptocrats calling the shots
As far as I can tell, the post only scratches the surface of 3) An insolvent, predatory banking sector. They fob responsibility off on to players at the national level, Spanish banks and the Greek government. Their solution is to take independence away from the Spanish banks and sovereignty away from the Greeks and vest it in the ESM which will be dominated by the North. Of course, the unaddressed issue, and its omission at this late stage can only be deliberate, is what about the Northern banks? the banks that made all these bad loans to the South. Once we see this the nature of the scam the authors are promoting becomes clear. The ESM loans are not about fixing Spanish banks or putting the Greek government on a sound financial footing. They are a pass through for ESM funds to flow back and recapitalize French, German, and Dutch banks. What the authors are proposing is a backdoor bailout of Northern banks at Southern expense. Criminality? Predation? Restructuring the Northern banks? Getting them to declare their losses? Their insolvency? Not a word, not one.
As solutions go, looking at my list of problems, I have to say this one is zero for six.
I’m trying to choose which river I should pitch my tent by after the global economy collapses and we’re all forced to live in tent cities. Any suggestions?
So everyone agrees, without discussing or explaining, that the banks must be bailed out somehow, because the alternative is … unthinkable.
Am I mistaken, or is the ultimate alternative that the banks just fail? Close the doors, turn off the computers. What exactly happens in that case? I assume that anyone who thinks they have money in “the banks” just loses it. That would include other banks, which might then also be brought down, domino-style. Credit freezes, economies more or less stop? Unemployment skyrockets, government revenues fall off a cliff? Economic depression and/or hyperinflation? Mass starvation? Dictatorships and world war? Realignment of civilizations? Or life goes on somehow.
I’m trying to visualize the world if this were to happen and it’s not coming in clearly. Maybe it’s too awful to describe.
The land of all, thanks blogger