Thursday, March 28, 2013

Slovenia to make banks pay for existing losses out of their future earnings

Reuters reports that Slovenia has rejected the EU model of confiscating deposits to pay for losses currently on its bank balance sheets and has decided instead to make the banks pay for these losses out of their future earnings stream.

Regular readers know that your humble blogger has been arguing that in a modern banking system, banks are designed to absorb existing losses in the financial system and recapitalize themselves through retention of future earnings.  It is nice to see my ideas are gaining international attention and acceptance.

Clearly, the Slovenia government accepts my premise.

As for the implementation...

Slovenia has been thrown into the spotlight as the next eurozone country likely to seek an international bailout, given the fragile state of its banking sector.... 
Part of the uncertainty still surrounding the country is due to adjustments that the new governing coalition - led by Prime Minister Alenka Bratusek - has pledged to make to the original 'bad bank' proposal put forward by the previous Janez Jansa administration. 
One of the key tweaks now under consideration, according to RBS, is the creation of internal bad banks within each of the country's largest financial lenders, postponing any transfer of toxic assets to an external bank asset management company to a later date. 
"Initially, bad assets would be transferred to the internal bad banks and backed simply by government guarantees," said Abbas Ameli-Renani, an emerging market strategist at RBS.
By keeping the bad assets on the bank balance sheets, the source for paying off the losses on the bad assets is future bank earnings and not the taxpayer.
Under the original proposal, assets would have been transferred immediately to the BAMC in exchange for newly-issued government bonds.
This would have taken the banks and bankers off the hook for paying for the losses on the bad debt and instead socialized the losses and made the taxpayers pay for the losses on the bad debt.
While there will be a simultaneous recapitalisation of banks under both arrangements, the new version would not result in an immediate spike in the government's debt level, because the authorities would initially provide banks with guarantees rather than newly issued securities. 
One of the downsides, however, is that the plan will keep bad assets on banks' balance sheets and under the same management.
Keeping the bad assets on banks' balance sheets is not a 'bug', but a feature.  By making the banks absorb the losses on all the excess debt in the financial system, the government is establishing how much in the way of future earnings must be retained to recapitalize the banks.

Going forward, the banks will retain 100% of pre-banker bonus earnings until they have rebuilt their book capital levels.

As for the new guarantees, because of deposit insurance, the guarantees are effectively already in place.

Please note, market participants already know a) that the banks are hiding significant losses and b) that the Slovenia government is standing behind its deposit guarantees.  This is why the banks are still operating despite the fact that they would have a low or negative book capital level if the losses were recognized.

To avoid the bankers gambling on redemption or trying to hide the losses on the bad assets, going forward the Slovenia government should require that the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert restraint on bank management behavior and ensure that the banks rebuild their book capital levels without excessive risk taking.

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