What to do with the losses on and off bank balance sheets?

In a Bloomberg article discussing the ECB's proposal that senior bank creditors share in any losses when a bank is closed, the OECD's William White observed

  “Bad loans have been made and the money is gone,” ... “The only interesting question right now is how the losses are to be allocated, who takes the hit. 

The people that lent the money imprudently should in principle, and I repeat, in principle, be the ones that pay the price.”

To date, the response in the EU, UK and US has been to protect the people that lent the money imprudently.

Regular readers know that this protection has been provided as a result of adopting the Japanese model for handling a bank solvency led financial crisis.  Under this model, bank book capital levels and banker bonuses are perserved at all costs (including being aware of and not stopping the ongoing Libor manipulation).

However, it appears that there is movement towards abandoning the Japanese model and adopting the Swedish model for handling a bank solvency led financial crisis.

Under the Swedish model, banks are required to recognize all their on and off balance sheet losses today.  Subsequently, they rebuild their book capital levels through a combination of retention of 100% of pre-banker bonus earnings and sale of capital instruments.

The first move towards the Swedish model was the BIS calling for banks to recognize their losses.

The second move towards the Swedish model was the ECB suggesting that senior bank creditors should absorb losses.

“The Spanish banks don’t have nearly enough subordinated debt to absorb their likely losses,” said Matt King, global head of credit strategy at Citigroup Inc. in London. “The authorities will do whatever they think is best for stability.  Until now, that has meant not inflicting losses on senior bondholders. But that may yet change.”... 

Under your humble blogger's blueprint for saving the financial system, the source for absorbing all of the existing losses is the capital currently on the bank balance sheets and unlimited future earnings (to the extent possible, bonuses should be clawed back too).

This should be applied to all banks that have a franchise that allows them to generate future earnings.

There will be some banks that do not have a franchise that allows them to generate earnings, these are the banks that need to be closed down.  These are the banks where the question of who absorbs the losses comes up.  Based on the US experience, the banks which don't have a franchise tend to be small banks and not banks with large amounts of senior debt.

When Anglo Irish Bank Plc collapsed, the Irish government was forced to prop it up, said Michael McGrath, a spokesman for the opposition Fianna Fail party.    “The ECB wouldn’t allow a bank failure,” he said. 

“Large European institutions would have been forced to take losses, with consequences through the entire system. So the Irish state recapitalized the banks to repay senior bondholders.”    

Under my blueprint, I take advantage of the fact that in a modern financial system banks are designed to be able to continue operating and supporting the real economy even if they have negative book capital. The reasons for this are deposit guarantees and access to central bank funding.

With deposit guarantees, taxpayers become the silent equity partner for banks with negative book capital levels.

So far, the discussion in the EU has not reached the stage where it is focused on taking advantage of this capability.  Instead, it is focused on closing banks with negative book capital and having senior debt holders absorb losses to the extent that there are still losses to absorb after wiping out the equity and junior debt holders.


This focus contributed to the idea of a spiral of financial contagion.  The losses on the senior debt would in turn cause banks that own the senior debt to collapse which would in turn cause the banks that own this senior debt to collapse...

“I don’t know of one big EU bank that’s gone down,” said John Whittaker, an economist at Lancaster University Management School. “The authorities are frightened to death, frankly.”...   

Thanks to the terrific sales job done by the bankers who had their bonuses at risk if the authorities had actually allowed the financial system to handle the bank solvency problem as it was designed to do.

 “Insolvency works very well for a widget maker, but not so well for a confidence-sensitive financial system,” said Satish Pulle, a fund manager at London-based European Credit Management Ltd., which oversees about $9.5 billion. 

Winding up banks at the expense of investors “may not be the best way forward in a systemic crisis,” he said. “You should not impose losses in a systemic crisis.”

Actually, if banks are required to provide ultra transparency and disclose on an on-going basis all of their current global asset, liability and off-balance sheet exposure details, then losses should be imposed on investors.  They had the information they needed to assess the risk of the investment and to adjust the amount and pricing of their exposure accordingly.

However, in the current circumstances where banks do not provide ultra transparency and financial regulators have represented that as a result of stress tests the banks are solvent, losses should not be imposed.  As a practical matter, there is a moral obligation to protect the investors from losses as the government has made a representation as to the safety of the investment.

Under my blueprint, the investors do not have to absorb the losses.