As EU heads towards common deposit insurance, it looks at question of how quickly to recapitalize banks

Bloomberg reports that as the EU heads towards common deposit insurance for its banks, it is now looking at the question of how quickly does a bank need to be recapitalized after it recognizes its losses on the excess debt in the financial system.

Regular readers know that the answer is banks don't have to be recapitalized immediately, but rather can rebuild their book capital levels over several years by retaining 100% of pre-banker bonus earnings.

The reason that banks don't need to be recapitalized immediately is the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers effectively become the banks silent equity partner when they have low or negative book capital levels.

To prevent banks from gambling on redemption after they have recognized their losses, banks must be required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants in combination with the bank regulators can exert restraint on risk taking by management.

The myth that banks need to be recapitalized immediately is solely a function of bankers attempting to protect their ongoing bonuses and shirk any responsibility for the losses that they incurred.  After all, a bank that is rebuilding its book capital level is highly unlikely to pay any cash bonuses.

Common deposit guarantees will be necessary to complete the European banking union project, Dutch Finance Minister Jeroen Dijsselbloem said. 

“That will be the final building block of the banking union, a necessary block,” Dijsselbloem, who heads the group of euro-area finance ministers, said at a conference in Brussels today. 

Precursors include new rules on bank resolution, common standards for national deposit guarantees and a European bank resolution scheme that is due to be proposed in June, he said. 

The euro area needs to press ahead with creating new tools to recapitalize banks, such as rules for when the European Stability Mechanism can provide direct aid, Dijsselbloem said. “We need to have the instruments to deal with the problems, because just exposing problems in banks and not having an answer” for recapitalizing them “would be very dangerous.”...

Actually, the only danger is to banker bonuses.

Since the beginning of the financial crisis, everyone knows that the banks have been hiding losses.  The only question is the true size of these losses.

The first step to exposing the problems in the banks is to require them to provide ultra transparency and disclose their current exposure details.

With this information, market participants can determine how large the losses are at each bank.

Then, the question becomes, which banks are still capable of generating enough income from their performing assets to cover their interest and operating expenses.  These banks stay in business and rebuild their capital levels.

Banks that cannot cover their expenses even after recognizing their losses and returning their bad debt into performing debt again should be resolved.

Dijsselbloem said today that the ECB will need to review asset quality as soon as it takes up its new duties, noting that there is “still the risk of contamination between banks.”

The ECB has said if depositors are protected consistently across the euro zone, including guarantees for small accounts and preference for uninsured depositors over other types of unsecured creditors, further measures aren’t needed for now. 

The current EU deposit-guarantee proposal “provides a harmonized framework and should help shore up confidence in national schemes,” said ECB Vice President Vitor Constancio in a March speech. “This means that a single European scheme is not an essential component of banking union in the short term.”