Let us look at the most recent rumor that a 50% haircut will be applied to Greece's debt. If true, this size haircut would cause significant losses for the Greek banks which own approximately 74 billion euros of Greek debt.
The question is what to do with the banks after they lose 37 billion euros. Should they immediately be recapitalized? If so, where should the funds come from - Greece or the European Financial Stability Fund?
The preferred alternative is NOT to recapitalize the Greek banks immediately, but rather let them recapitalize themselves over time through retained earnings and, when it makes sense, public stock offerings.
For this alternative to work a couple of assumptions must be true:
- Each of the Greek banks has a franchise that is capable of generating sufficient earnings over a reasonable time period to restore compliance with international capital regulations. There might have to be some mergers between existing Greek banks to create larger banks with this earnings capability.
- Each of the Greek banks must disclose its current assets and liabilities on an on-going basis so that market participants can monitor their performance and risk profile. One of the benefits of this disclosure is that with the ability to assess risk comes improved access to the capital markets.
[Note: regular readers know that in the late 1980s the US savings and loans essentially had no capital, but were allowed to keep operating. During this period, they were very aggressive in making loans (some call it gambling on redemption). The reasons the savings and loans did not recover was they did not have a franchise capable of generating sufficient earnings or disclosure so that their activities could be monitored. Both of these should be addressed if Greek banks are going to be allowed to recapitalize themselves over time.]
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