Thanks to Cyprus, issue of who pays for bank losses re-emerges

By proposing to violate the sanctity of deposit guarantees to help fund its bailout of its banks, Cyprus has put the issue of who pays for bank losses back onto the agenda.

Thank you Cyprus and by extension Germany, Finland and the IMF.

Regular readers know that a modern banking system is designed so that the banks can pay for their losses, but that since the beginning of the current financial crisis, politicians have prevented this from occurring and instead have made savers and/or taxpayers pay for the banks' losses.

Let me unpack the bolded statement.

A modern banking system is designed so that banks can absorb the losses on the excess debt in the financial system and continue to operate and support the real economy even if the banks have low or negative book capital levels.

Why?

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 they have low or negative book capital levels.  With this "silent equity partner", banks can continue to extend the credit that the real economy needs for growth.

The idea that banks can continue to operate with low or negative book capital levels doesn't appear in any textbook or article in a scholarly journal.  What proof is there that the modern banking system is designed to act this way?

Let me provide you three examples that confirm the banking system is designed to act this way.

First, in the mid-1980s, the write-down of loans to Less Developed Countries meant that Security Pacific effectively had negative book capital.  This fact was well known to market participants as they knew the size of Security Pacific's exposures, the size of write-downs other banks were taking on similar exposures and how much book capital Security Pacific had before the LDC write-downs began.

Not only was Security Pacific not closed, but it was allowed to engage in a large acquisition (Rainier) to help it rebuild its book capital levels (pooling accounting).

Second, in the late-1980s, the US Savings and Loans saw their book capital disappear as a result of losses incurred in a rising interest rate environment by the mismatch in pricing between their assets and their liabilities.

The savings and loans didn't go away.  Rather they continued in operation, some would say gambling on redemption by making loans to real estate developers, until closed by the financial regulators several years later.

Third, in 2008, Citigroup's book capital level dropped to what can only be described as a low level.  Citigroup was not closed.

In each of these examples, despite low or negative book capital levels, the financial institutions continued to operate and provide credit to support the real economy.

In each of these examples, the ultimate authority that made the decision to close or not close the financial institutions was the financial regulator responsible for protecting the deposit insurance fund and the taxpayers and not the debt or equity markets.

What ultimately caused the savings and loans to be shutdown is that their franchise was unable to generate earnings that could be retained to rebuild their book capital levels and reduce the risk of loss to the deposit insurance fund and taxpayers.

Please note, that while the examples were drawn from the US, just from the latest financial crisis there are numerous international examples too.

The fact that a modern banking system is designed to absorb the losses on the excess debt in the financial system is inconvenient for policymakers and bankers.  

It is inconvenient because it provides an alternative to savers and/or taxpayers as the answer to the question of who pays for bank losses.  The alternative being the banks and bankers themselves by applying as much of their future earnings as is needed to absorb the losses.

Since the beginning of our current financial crisis, global policymakers have been pursuing a strategy of protecting bank book capital levels and, with it, banker bonuses at all costs.

They have done so under what I have called the Japanese Model (named after the failed policy response that Japan has been pursuing for the last 2+ decades to its financial crisis).  The Japanese Model always fails as a policy response because it is fundamentally flawed.

In protecting bank book capital levels, the Japanese Model allows the banks to kick the can down the road on recognizing losses.  This is not a costless exercise.  In fact, the cost of carrying those losses is very high.

The cost of carrying the losses includes zero interest rate and quantitative easing policies (which hit savers), fiscal stimulus (which hits taxpayers through the additional debt governments take on) and austerity (which hits the poor through a reduction in social programs).

What Cyprus did by "taxing" bank depositors was to simply speed up the process by which financial repression under the Japanese Model takes money from the savers and gives it to the banks (notice that no bankers in Cyprus were going to lose their jobs despite losing billions).

This confiscation of saver funds put the issue of who pays for bank losses back on the agenda.

Why?

Because the savers and taxpayers now know that their governments could also confiscate their deposits without warning to absorb the bank losses.  The lack of warning highlights the simple fact that savers and taxpayers were never consulted about who should pay for the bank losses at any time since the beginning of the financial crisis.

Having been fooled once into paying for the banks' losses, savers and taxpayers are now unlikely to be fooled again.

Germany provides confirmation of this as the current German government is facing defeat because the German citizens are tired of paying for bank losses that could and should be paid for by the banks themselves (even if this means that bankers' cash bonuses will be reduced).