Praying that Spain and the EU work out their banking crisis

Four years after adopting the Japanese model for handling a bank solvency led financial crisis, the point at which denial and covering up no longer works has been reached.

It has become clear to everyone that the EU (and UK, US, China and Japan for that matter) has not come remotely close to dealing with the banking crisis.

As Philip Aldrick observed in his Telegraph column,

[Spain’s] banking crisis is threatening to sink the nation. Around €100bn was pulled out of Spanish banks in the first three months of the year, €66bn in March alone, on concerns about the solvency of the institutions. 

At about 5pc of deposits, the “bank jog” – as some wags have billed it – is in danger of turning into a full-blown “bank run” that would send Rajoy back to Washington – this time cap in hand. 

“We are in a situation of total emergency, the worst crisis we have ever lived through,” Felipe Gonzalez, Spain’s former prime minister, said last week. The following day, Olli Rehn, Europe’s economics commissioner, warned that the eurozone was on the brink of “disintegration”. Greece, Portugal and Ireland might be small enough to contain, but Spain, the currency region’s fourth largest economy, poses a far more dangerous threat.... 

As predicted by your humble blogger, the Japanese model would never solve the banking crisis.  While I firmly believe there are some benefits to prayer, I think policymakers should not make praying for a miracle the foundation of the policy response to the financial crisis.

The result of adopting the Japanese model and praying for a miracle was to turn a financial crisis into the worst crisis we have ever lived through.  The human cost of the economic stupidity of choosing the Japanese model is now apparent to everyone, but the policymakers and financial regulators.

Rather than a bail-out, though, Santamaria was seeking to drum up international support for an alternative proposal – a eurozone-funded bank rescue that would not cripple Spain’s public finances.  

According to some estimates, Spain needs to inject €100bn into its banks to cover the vast volumes of bad real estate debt on their books – €19bn of which has already been earmarked for its giant domestic lender, Bankia. 

But the size of such a recapitalisation would destroy the nation’s finances, piling more on the country’s €850bn borrowings and – if made to pay between 5pc and 6pc for the new money – plunging the economy into an unsustainable debt trap. 

The lessons of Ireland, whose public finances were wrecked by rescuing the banks, loom large.

Please re-read the highlighted text as it shows one of the costs of needlessly bailing out the banks.

Instead, Spain wants to change the terms of the eurozone’s €500bn rescue fund, the European Stability Mechanism (ESM), to allow it to invest directly into banks rather than through governments. 

Santamaria made the purpose of her Washington visit plain after meeting Geithner. “We were talking about the possibility that the banks, not only Spain’s but also in other countries who need it, could access funds directly without intervention from the governments and without conditions,” she said. 

“The Treasury Secretary indicated that we are working in the same direction and that we must find a solution for the banks.”

Having exhausted the capacity of countries like Spain to pay for the bankers' bonuses, the bankers shift their target for funding their bonuses to other potential sources of funds.

Support in Europe is gathering for the proposal. If Greece is not expelled from the eurozone after its June 17 elections, it will also require bank recapitalisations. Even France could potentially use the funds for its weaker lenders. Italy does not want to be the next domino to fall, so wants Spain as a buffer between it and the bond vigilantes. And Portugal’s economy is hugely dependent on the success of Spain. 

In Brussels, too, there is a growing consensus. On Wednesday, the European Commission was the first to raise publicly the idea of direct capital injections by the ESM, instead of routing funds through governments already saddled with huge debts. “To sever the link between banks and the sovereigns, direct recapitalisation by the ESM might be envisaged,” the EU executive said....

Regular readers of this blog know that the link between banks and sovereigns is easily cut by the policymakers requiring the banks to retain future earnings to recapitalize themselves.

There is no need in a modern banking system for sovereigns to inject a single euro into a bank.

With deposit insurance and access to central bank funding, banks with negative book capital levels can operate and support the real economy for years while they retain their earnings to rebuild their book capital levels.

The only individuals who think that banks need capital are a) policymakers and regulators looking to be employed by or receive a significant amount of money from the banks after they 'retire' from their current position, b) economists who by definition know absolutely nothing about how the financial system actually works and c) bankers who need the money to pay themselves a bonus.

Banks have once again shuffled uneasily back into the centre of the crisis, not just because of the potential losses they are carrying but also because, without a functioning banking sector, countries will never be able to grow their way back to financial health.

However, a functioning banking sector does not require banks to have a positive book capital level.

This is a very important point (for anyone who doubts that banks can still take in deposits and make loans while they have negative book capital levels, please look at the US Savings and Loans in the late 1980s; they took in deposits and made loans while their regulator allowed them to use TRAP - terribly rotten accounting principles - to try to disguise their negative book capital).

“Spain needs to clear up its banking system and it needs to be done rapidly,” said Bill Rhodes, a former senior vice-chairman of Citigroup and veteran of bank and sovereign rescues from the Latin American and Asian debt crises. 

The fastest way to clean up the banking system is to require the banks to recognize all the losses hidden on and off their balance sheets.

At the same time, banks should be required to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details so market participants can confirm that all the losses have been realized.

“If you don’t get the banks lending, you won’t get growth. It’s particularly true in parts of the eurozone, which do not have deep capital markets so are highly dependent on the banks. That’s the key element that’s been missing so far.”...

What would get the banks lending again is if the EU financial regulators would drop their misguided policy of having the banks reach a 9% Tier I capital ratio by the end of June 2012.  With the banks not having recognized all their losses yet, everyone knows the ratio is meaningless (the OECD agrees).

The EU banks cut back on lending to reach this meaningless ratio.

Recapitalising Spain’s banks without jeopardising the nation’s finances could potentially restore market confidence and draw institutional funds back, giving the lenders the money to start the crucial business of extending credit once again. 

“If in Spain things are done right, the risk premium comes down and we start seeing capital flows moving normally again, that will be a touchstone for the euro project to continue ahead,” Mr de Guindos said. 

“If not, we will have problems for the euro project itself, as we know it,” he added.

Recapitalizing Ireland's banks did not restore market confidence (they are still experience a 'bank jog') nor did it restart the normal flow of capital.

You cannot restart the normal flow of capital while the banks are still sitting on their losses.  It is easier for a zombie borrower to get credit than it is for a creditworthy borrower.  Until this is reversed, capital will not flow normally.