Germany's policy: banking sector must contribute to recapitalizing banks

As the search for a solution on how to recapitalize Cyprus' banks continues, one thing has become clear.  Germany has adopted a new policy under which it will no longer contribute substantial funds to bailout another EU country's banking sector.

The new German policy can be summarized as:  the banking sector must contribute to recapitalizing the banks.

Regular readers know that this is what your humble blogger has been saying since the beginning of the financial crisis.

There is no legitimate reason why a government should issue debt to bailout the banks and Germany has correctly recognized this.

The question is how to get the banks to contribute 100% of the bailout funds.

What distinguishes my answer to this question from the approach initially proposed by Germany to Cyprus is how I handle the issue of how quickly the banks need to be recapitalized.

My approach recognizes that a modern banking system is designed so that banks do not have to be recapitalized immediately.  This is a very important point as it is the reason that banks can provide 100% of the bailout funds through retention of future earnings.

Banks are designed so that they can continue operating and supporting the real economy even when they have low or negative book capital levels.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

Deposit insurance effectively makes the taxpayers the banks' silent equity partner when the banks have low or negative book capital levels.  This permits the banks to continue to make loans and handle payments.

Germany's approach of requiring the depositors to take a haircut is driven by their assuming that banks have to be recapitalized immediately.  Something that is not true, but has been obscured by Japan, the UK and the US pursuing policies of protecting bank book capital levels and banker bonuses at all costs.