Germany ends 5 years of bailing out banks, sets stage for EU wide adoption of Swedish Model

As the Wall Street Journal reports, one good thing came out of the most recent EU leaders meeting in Brussels:  it is now clear to everyone that Germany and the rest of the AAA EU countries are not going to provide funding to bailout any EU bank for their existing bad debt.

German Chancellor Merkel should be praised for eliminating any excuse for continuing to pursue the Japanese Model for handling a bank solvency led financial crisis.  Under the Japanese Model, bank book capital levels are protected at all costs including bankrupting the host country to bailout the banks.

Merkel explicitly said that Germany has no interest in bailing out the banks for their existing bad debt problems.

Since Germany and the rest of the AAA EU countries are not going to fund the bank bailouts, it is time to drop the Japanese Model and, following Iceland's lead, embrace the Swedish Model for dealing with a bank solvency led financial crisis.

Regular readers know that under the Swedish Model banks are required to recognize upfront the losses that they would absorb if all of the bad debt was allowed to go through the multi-year restructuring/bankruptcy process.

As a result of absorbing these losses, the real economy is protected, families get to remain in their homes and social programs can be expanded.

Also, banks will find themselves with low or even negative book capital levels.

This is not a problem as the design of a modern financial system allows banks to continue to operate and support the real economy even when they have low or negative book capital levels.  Banks can continue in operation when non-financial firms cannot because of the existence of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers effectively become the silent equity partner of the banks when the banks have low or negative book capital levels.  In exchange for this silent equity, banks are required to retain 100% of their pre-banker bonus earnings to rebuild their book capital levels and reduce the taxpayers' exposure.

German Chancellor Angela Merkel took a hard line on Spain Friday, saying that Madrid will have to keep on its own balance sheet the tens of billions of dollars it is about to inject into its banks and won't be able to transfer them to the euro-zone bailout fund. 

That position, laid out after a two-day summit of European Union leaders in Brussels, would mean that Spanish borrowing from the euro zone to bolster the capital of shaky banks—estimated to be as much as €60 billion ($78.72 billion)—will swell the country's already-heavy debt load. 

Germany's stance appeared to dash hopes, fostered by the leaders at a summit in June, that the government's capital injections into the banks could later be transferred to the bailout fund once an effective euro-wide bank supervisor is in place, something that is now slated for 2013. 

The position could hurt the Spanish government's ability to fund itself on the market, just as interest rates on its bonds have dropped to multi-month lows. 

"There will be no retroactive direct bank recapitalization [for Spanish banks]," Ms. Merkel told reporters. "As and when direct recapitalization is possible, it will apply only in the future."...

Regular readers know that by design banks in a modern financial system do not have to be bailed out by their host country (see discussion above of why banks can operate with low or negative book capital levels).

This fact is known to Ms. Merkel.

Ms. Merkel's decision to set out her position in her post-summit news conference is significant, however, and signals that Germany is taking a tough stance in the negotiations.  

Actually, Ms. Merkel's statement is not taking a tough negotiating stance.  Germany has consistently said that it was not interested in bailing out the banks.

Ms. Merkel is simply saying to stop pursuing the Japanese Model and adopt the Swedish Model instead to end the bank solvency led financial crisis.