Monday, July 16, 2012

ECB calls for senior bank debt holders to share losses is implicit endorsement of Swedish model

The ECB has taken the first step towards endorsing adoption of the Swedish model for handling a bank solvency led financial crisis by calling for senior bank debt holders to absorb losses.

Under the Swedish model, banks recognize the losses on all of their on and off-balance sheet exposures today.  Subsequently, they rebuild their book capital levels by retaining 100% of pre-banker bonus earnings.

Included in the losses that banks would realize are the losses on the senior debt of other banks, particularly in the EU peripheral countries.

According to a Wall Street Journal article,
The European Central Bank, in a sharp turnaround, advocated imposing losses on holders of senior bonds issued by the most severely damaged Spanish savings banks—though finance ministers have for now rejected the approach, according to people familiar with discussions.... 
It marks a contrast from the position the central bank adopted during the 2010 bailout of Irish banks—which, like Spain's, were victims of a property meltdown—when it prevailed in its insistence that senior bondholders in bailed-out banks shouldn't suffer losses.
Under the Japanese model for handling a bank solvency led financial crisis that was adopted at the beginning of the crisis, bank book capital levels are protected at all costs.  As a result, senior bondholders couldn't absorb any losses.

In shifting to the Swedish model, bank senior bondholders are now not only not protected from loss, but required to recognize the loss.
The ministers rejected the advice from the July 9 meeting out of concern financial markets would react badly....
The ministers' advisors, bankers, know their bonuses are at risk, hence the concern that the markets would react badly.  If the ministers adopt the ECB recommendation, their banks are going to have losses and they might not receive a bonus.
The ministers' decision confirmed a pattern in the euro zone for dealing with bank troubles in which senior bondholders have been spared even in the most brutal failures. 
But the ECB's shift may be a sign that the tides are turning on the issue, as the euro zone embarks on a fundamental overhaul of the way bank failures are dealt with within the currency union....
Imposing losses on bondholders reduces the amount of money taxpayers need to inject into struggling banks. One euro-zone official said the desire to avoid putting more public money at risk than necessary was one reason behind the ECB's change of heart since 2010.
As your humble blogger has said repeatedly, there is no reason that governments need to put more money at risk.  They already have plenty at risk through the deposit guarantee.

Regular readers know that a modern banking system is designed to continue to operate even if the banks have negative book capital levels.  The reason this is true is the existence of deposit guarantees and access to central bank funding.

With the deposit guarantees, the taxpayer through the government guarantee has become the silent equity partner in the bank when it has a negative book capital level.  This is the reason why it is only governments that can shutdown a bank.  

As the silent equity partner, the government has the option of looking at the bank and seeing if it has a franchise that would allow it to earn its way back to a positive book capital level or can be sold in such a way as to minimize the losses incurred by the taxpayer.

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