Wednesday, May 30, 2012

EU still searching for way to stop bank run contagion caused by redenomination risk

The EU is scrambling to find a way to stop the risk of bank runs across the peripheral countries if Greece is forced back onto the drachma.

Regular readers know that your humble blogger has suggested an easy solution:  adoption of the Swedish model with ultra transparency.

Under this solution, the banks will absorb the losses on the debt in excess of the borrower's capacity to repay.  If this were done, then Greece would not be forced onto the drachma and the risk of bank run contagion resulting from forced redenomination would go away.

As reported by Reuters, the EU is pursuing alternatives endorsed by bankers that don't require the banks to recognize the losses hidden on and off their balance sheets.

As the euro zone ponders a possible Greek exit, policymakers have not yet built a shield robust enough to prevent a bank run in one country sending others in the bloc deeper into crisis.... 
But a wave of withdrawals by depositors - either for fear that their government is too weak to stand behind its banks or that their country will exit the euro and switch their savings into a vastly devalued national currency - would represent a whole different scale of crisis. 
Such pressure on Ireland's banking system prompted a national bailout by the International Monetary Fund and European Union. 
Now investors are worried about the contagion effect a Greek exit from the euro zone could have on savers in other countries. 
"Preventing bank runs in Italy, Spain and Portugal should be the top priority," said Berenberg Bank economist Holger Schmieding. "Policymakers need to make sure that the potential Greek precedent of a forced conversion of domestic euro deposits into a weak new currency would not spark a run on banks ... elsewhere."
Bank runs in these other countries are already taking place.  
The ECB is pressing the euro zone to set up a fund that would prevent this dangerous ripple effect, a message reinforced by ECB policymaker Joerg Asmussen last week. 
"The recapitalization of a troubled bank by its government may lead to a deterioration of the government's fiscal position," Asmussen said. "The deteriorating fiscal position in turn further weakens banks' balance sheets, through their holdings of sovereign bonds. 
"This feedback loop has to be stopped ... A European bank resolution authority and a European deposit insurance scheme are two elements that could be used to address the nexus between sovereigns and banks."
Adopting the Swedish model with ultra transparency stops the feedback loop.

As regular readers know, in a modern financial system with deposit guarantees and access to central bank funding, banks can operate and support the real economy for years with negative book capital levels.

In fact, a modern financial system is designed so that bank book capital is suppose to act as a safety valve between the excesses in the financial system and the real economy.  Banks do this by absorbing the losses on the excess debt in the financial system today and rebuilding their book capital levels through retention of future earnings.

There is no reason in a modern banking system for governments to recapitalize the banks.  As the IIF pointed out, the banks in Spain should generate enough earnings over the next 4 years to absorb all the losses that the IIF forecast.

Finally, I agree with the call for a European deposit insurance scheme.  It is part of my blueprint for saving the financial system.
Any pan-euro zone deposit guarantee scheme would need to be large in order to stem ebbing confidence. 
The typical national guarantee in Europe now covers the first 100,000 euros on deposit, something that would do little to reassure corporate investors with millions. 
It was the decision by companies in Ireland to withdraw deposits that accelerated its banking crisis....
Under my blueprint, the combination of the European Financial Stability Fund and the European Stability Mechanism is more than adequate as the only banks that need to be restructured or closed are those banks that do not have a viable franchise.  Where viable reflects the capacity to rebuild their book capital levels through retained earnings.
In the absence of a resolution fund or insurance scheme to deal with a bank collapsing, many investors expect the ECB would act to head off a bank run or a similar systemic threat.... 
In the case of Greece, the belief is that the ECB would act again to contain a bank run, said Clemens Fuest, a professor at Oxford University and a member of the academic advisory board of the German Federal Ministry of Finance. 
"The expectation seems to be that the ECB will prevent it by providing whatever liquidity is needed," he said, adding that this could either be from the ECB directly or as emergency funding from the Bank of Greece with the ECB's backing....
It is comments like this that reflect how little academics understand about a modern banking system and deposit guarantees.

In a modern banking system with deposit guarantees, depositors do not care about the current level of bank book capital or whether the bank is currently solvent or not.  All depositors care about is that the guarantee will be honored.

There are two reasons the guarantee might not be honored.  First, the sovereign does not have the financial capability.  Second, deposits are subjected to forcibly exchanged from a stronger currency into a weaker currency.

In the presence of either of these reasons, there are bank runs.

What the ECB can and does do is provide liquidity to the banks so that depositors can withdraw their funds.  
The banking environment has steadily deteriorated, according to statistics from the Bank for International Settlements, which chart the flight of capital from the euro zone's weakest members. 
Figures from December last year show a sharp decline in deposits from abroad held in banks in Greece from $160 billion in late 2009 to less than $80 billion. 
Ireland's bank deposits from abroad fell from $905 billion to $471 billion over that time and a similarly sharp fall was seen in Portugal. 
Households and companies have almost 11 trillion euros on deposit with banks in the euro zone, with over 3 trillion in Germany alone, according to ECB statistics....
Further confirming the on-going bank run from the EU periphery countries to the core countries.
Draghi is pressing governments rather than the ECB to take the decisive action and delivered a stark message last Thursday, saying: "We have reached a point in which the process of European integration needs a courageous leap of political imagination in order to survive."
The courageous leap of political imagination is to adopt the Swedish model with ultra transparency.

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