Europe's stricken banks wait for rescue

As the Bank of England's Mervyn King has pointed out, we are dealing with a global bank solvency problem.

What Heather Stewart discussed in her Guardian column is that EU policymakers and financial regulators have adopted policies that don't address this bank solvency problem.

As regular readers know, in fact, the adopted policies will never deal with the bank solvency problem as they are the direct result of choosing the Japanese model for handling a bank solvency led financial crisis and explicitly protecting bank book capital levels.

Why protect bank book capital levels?  One of the major reasons is because financial regulators and economists believe that banks having positive book capital is a necessary condition for preventing runs on the banks by the depositors.  This is a statement of belief which the facts show is totally false.

For example, when FDR took office, the US banking system was experiencing a bank run.  His administration's response was to declare a bank holiday, implicitly guarantee bank deposits and re-open only "solvent" banks a couple of days later.  Everyone knows that there was not adequate time to determine that the banks were solvent, but depositors did not care because of the implicit guarantee.

Another example occurred in connection with the Latin American Debt Crisis when it became apparent that countries could in fact default and the loans to less developed countries on the largest US bank balance sheets would have to be written down.  Market participants knew that the banks were insolvent (the market value of their assets was less than the book value of their liabilities), but there was no run on the banks as the deposits were guaranteed.

Yet another example was the US Savings and Loan crisis where virtually everyone of these financial institutions was insolvent.  These firms showed that insolvent financial institutions can attract deposits if they offer an attractive interest rate and are guaranteed.

Finally, the current financial crisis shows that there are two ways to overcome the deposit guarantee and create a run on the bank.  First, the sovereign that is providing the guarantee can take on so much debt that it doesn't look like it can perform on its guarantee (Ireland).  Second, there can be the threat of converting the deposits to a less valuable currency (Greece).

The necessary condition for preventing bank runs is to have a credible deposit guarantee.

When a credible guarantee is in place, depositors don't care about bank book capital levels.  It is this lack of concern that gives banks in a modern financial system the ability without government bailouts to absorb the losses on the excess debt in the financial system today and rebuild their book capital through future retained earnings.

In all the eurozone's struggling peripheral economies – Italy, Greece, Portugal and Spain – governments and banks are locked together in what Sony Kapoor, of Brussels-based thinktank Re-Define, calls a "dance of death". 

The weaker each economy becomes, the more bad debts its banks are forced to declare; and the more likely it is that their governments will be forced to set aside fresh resources to recapitalise them. 

At the same time, much of the banks' capital base – their safest assets – are made up of the bonds of their home country's government, which become shakier investments as the governments are forced to stand behind their banks....

Ending this 'dance of death' requires the realization that the governments are already standing behind their banks' depositors.  As a result, governments do not have to explicitly bailout the banks.

A bank run of the sort that helped bring down Northern Rock in the UK is one of the greatest fears facing Europe's leaders, because once panic-stricken savers take matters into their own hands, their fears can quickly become self-fulfilling. 

If a "Grexit" did materialise, businesses and consumers could respond by pulling their money out of financial institutions, not just in Greece but also Spain, Italy, Portugal and even Ireland, as they contemplated the possibility that others could follow Athens out of the single currency. 

Megan Greene, director of European economics at Roubini Global Economics, says: "The biggest risk over the next month is from a bank run."

This is why your humble blogger has been arguing for a change in the current Japanese model related policies that undermine the deposit guarantee and make a bank run more likely.

There may not have been queues outside branches, but already deposits in Greek banks are down by almost a third since before the crisis, and central bank governor George Provopoulos said that withdrawals had hit €700m in a single week. "We're seeing a 'bank jog' in Greece already," Greene says. 

"People have been withdrawing deposits right, left and centre," agrees Neil Mellor of BNY Mellon. 

This blog has been documenting the on-going EU bank run for months.

Greene believes European politicians could assuage savers' concerns in the coming days by declaring a Europe-wide deposit protection scheme; but that would fall foul of Germany's opposition to offering blanket support to struggling states. 

"No one is going to feel very calmed by the Greek government saying 'We're going to backstop all your deposits,'" she says. 

Hence the reason that I recommended that the European Financial Stability Fund and the European Stability Mechanism backstop the states' deposit guarantees.

Danny Gabay, director of City consultancy Fathom, says what Europe faces is fundamentally a banking crisis. "It's not who borrowed: it's who lent," he says. "That's the problem. The people in their tents outside St Paul's were not complaining about the person who borrowed six times their income; they were complaining about the banks, which should have known better."...

Bank solvency has been the issue since the beginning of the financial crisis.  The reason that the interbank lending and unsecured debt markets froze is that no one can tell which banks are solvent and which are not.

But ultimately, most analysts believe whatever Greece decides in a month's time, the crisis is unlikely to be cauterised until politicians make what Mellor calls a "monumental, megalithic decision": to allow the ECB to freely lend cash-strapped banks as much as they need to stay afloat; and to allow eurozone governments to stand behind each other, come what may.

Please re-read the highlighted text as this monumental, megalithic decision will end banker bonuses as we know them for the foreseeable future.

Should the decision be to adopt my low cost blueprint for saving the financial system, the EFSF and ESM are sufficient to maintain depositor confidence in the deposit guarantees.  Particularly, when the banks are required to provide ultra transparency so that market participants can exert discipline to restrain the riskiness of the banks.