Does it matter when banks loaded with bad debts are recapitalized?

Does it matter when banks facing a solvency problem from over-exposure to bad debts are recapitalized?

Yes.

It is far easier to get banks to recognize their losses upfront on their bad debt before they are recapitalized.

After the banks are recapitalized, they will delay as long as possible recognition of their losses.

This is a very important point.  If policy makers and financial regulators want to clean up all the bad debt in their banking system and restart their national economy, the time to clean up all the bad debt is before the banks are recapitalized and not after the banks are recapitalized.

This can easily be shown with Iceland and Ireland.

Iceland required its banks to recognize upfront the losses that they would incur if all the bad debt in the financial system went through the long bankruptcy process.  This protected the real economy, kept families in their homes and allowed Iceland to expand social benefit programs.

Subsequently, Iceland's economy is growing, unemployment is falling and the banks are retaining their earnings to rebuild the level of book capital on their balance sheets.

Ireland injected equity into its banks and its policy makers and financial regulators are now wrestling with the banks to get them to recognize the losses on the bad debt and restructure the loans.

As a result, the real economy is still being burden by the debt service expense of the bad debt, families are losing their homes and social benefit programs are being cut back.

This experience is not unique to Ireland.  The same behavior has been exhibited by bankers where ever they have received a bailout.

As reported by the Irish Independent,

The Central Bank's director of bank supervision Fiona Muldoon said banks were in denial about the extent of the mortgage crisis, and were refusing to come up with realistic solutions....

"I see too much lip service to 'progress' and 'meaningful resolution' and not enough to 'reality'. I see too much 'give the Central Bank exactly, literally, what they asked for' and not enough true dialogue and meaningful engagement to find a solution," she said yesterday. 

"I see way too many 'extend and pretends' masking as solutions . . . yes, a lot has been done but the hard stuff is only getting started and it is taking too long, and too much of it is driven by the regulator." 

She said resolving the mortgage arrears crisis -- particularly with 167,000 residential mortgages in trouble -- was vital for the health of the economy... 

There had been talk of solutions for heavily indebted householders for four years now, Ms Muldoon told the conference.But nothing had happened, and instead banks had been hoping for an economic recovery that had not arrived. 

"This is the stuff of denial. Hope is not a strategy -- any more than anger."... 

In a related Irish Independent article,

THE banks must do deals with tens of thousands of homeowners struggling to pay their mortgages, the country's most powerful civil servant has demanded. 

Our economy will end up crippled for years unless banks grapple with the thorny issue of mortgage debt write-offs, Department of Finance secretary general John Moran said. 

Householders who are "hopelessly" in debt, with no chance of getting on top of the situation, need to have debt written off, Mr Moran warned. 

He told bankers at the annual conference of the Irish Banking Federation that households with "unsustainable debts" they simply could not repay were a drag on the economy.....

A bigger problem, he said, was the households that were not in arrears but were also not spending in the economy. 

This was a trend that was keeping the domestic economy from returning to growth. 

Mr Moran told the Irish Banking Federation conference that banks were nervous of lending but needed to help get those households back spending if the economy was to recover. 

Restoring the confidence of financially viable households would stimulate the wider economy, he said. This was a "very large prize" worth winning.

Finally, as reported by the Irish Times,

BANKS MUST face up to the issue of restructuring rather than just deferring problem SME loans, the deputy governor of the Central Bank said yesterday...

He said that, while banks have begun addressing the issue of restructuring mortgage arrears, an in-depth analysis commissioned by the Central Bank shows that, to date, they have failed to show a similar appetite for facing up to the issue of problem SME arrears. 

“It appeared that portfolios were largely subject to rescheduling and extended forbearance rather than a determined effort to restructure loans and deploy a wide range of workout options,” said Mr Elderfield who is head of financial regulation at the Central Bank.

The failure to clean up the 'zombie' loans acts as a drag on the real economy.

While the Central Bank would not be rolling out the same extensive regulatory framework it has done for mortgages, it would be pressing the banks to decisively tackle the recovery and, as necessary, restructuring problem SME loans, he said.