Regular readers know that a modern banking system is designed to handle failing banks without costing taxpayers any money.
A bank "fails" when it becomes insolvent and the market value of its assets is less than the book value of its liabilities.
However, just because a bank is insolvent doesn't mean that the bank has to stop operating and supporting the real economy. Modern banks are designed to operate and support the real economy even when they are insolvent.
How can banks that fail stay in business?
The combination of deposit insurance and access to central bank funding let banks stay in business even when they have failed and are insolvent. When banks are insolvent or have either low or negative book capital levels, deposit insurance effectively makes the taxpayers the banks' silent equity partner.
As a result, the only market participant who can close a failed bank is its regulator.
Under what condition should a failed bank be allowed to continue to operate and support the real economy?
So long as the bank can continue to generate earnings, it should be allowed to continue to operate. 100% of these earnings before banker bonuses are retained and used to rebuild the bank book capital level and reduce the taxpayers' exposure to the bank.
To prevent the bank's managers from gambling on redemption, the bank must provide ultra transparency and disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details. With this information, market participants and regulators can exert discipline to restrain the banks risk taking.
Under what condition should a failed bank be resolved?
When it cannot generate earnings for its core banking franchise.
But doesn't this mean that the taxpayer is on the hook for the losses when this bank is resolved?
No, the industry is on the hook for the losses. The industry pays for deposit insurance. The cost of deposit insurance increases to cover these losses.
So the answer to the question of who pays for all the losses on the legacy assets is first, the bank that holds these assets if they have a franchise that lets them generate earnings and second, the banking industry through higher assessments on their deposit insurance.
European Union chiefs pledged to seek a joint strategy for handling failing banks as German Chancellor Angela Merkel demanded taxpayers be spared the costs.
Leaders agreed to start work next year on a single resolution mechanism for euro-area banks to complement the European Central Bank oversight role approved yesterday by European finance chiefs. Lenders should underwrite financial stability by repaying governments as needed, EU leaders said.
Resolution “may not be at the cost of the taxpayers, but has to be structured so that those responsible for the failures of the banks carry the burden,” Merkel told reporters at 2:15 a.m. after nine hours of talks in Brussels.
Bolstering confidence in banks is a key component of policy makers’ effort to defeat the debt crisis that has rattled markets since late 2009. They must decide how to handle existing bank weakness as well as future failures that emerge after the ECB takes on its oversight duties. In the first half of 2013, they will seek a deal on the terms of allowing the EU’s 500 billion-euro ($656 billion) rescue fund to provide direct aid to banks.
“We made progress” on a resolution mechanism, said ECB President Mario Draghi. He pressed government leaders to confront how they will handle banking woes that spread across borders and exacerbate financial crises.....