Protecting bankers, Germany says "liability cascade" must prevail in bank bailouts

I keep wondering how many times bankers must be protected from the consequences of their actions until global policymakers realize that this protection does not a) result in banking systems that are fixed or b) economic growth.

In the latest round of protecting the bankers, Germany has called for rescuing the banks by enforcing a liability cascade that starts with shareholders and moves towards and includes depositors.

Regular readers know that based on how modern banks are designed the number one source for rescuing and recapitalizing banks is future bank earnings.

Please note the difference between recapitalizing banks using future earnings versus using deposits.
 
When future earnings are used, banker effectively "pay" for the damage they did to the bank because their cash bonuses are minimized until bank book capital has been rebuilt.

When deposits are used, bankers keep receiving their cash bonuses while the depositors and the real economy suffer the losses.

Plans in the euro area to allow the direct recapitalization of failing banks must stick to a hierarchy of responsibility that starts with the banks’ shareholders, the German Finance Ministry said. 

In its report for April, the ministry said a “liability cascade” must prevail in any attempt to save a bank, allowing the European Stability Mechanism to allocate resources on its main job of averting state insolvencies. 

“From the German government’s point of view, it’s important to limit the volume for direct recapitalization to allow the ESM to focus on its core task,” the ministry in Berlin said today. “It’s also important that the liability hierarchy is followed,” it said, echoing comments made by Finance Minister Wolfgang Schaeuble in Brussels this month.

All of Germany's stated goals are more easily achieved by tapping unlimited amounts of future bank earnings as a source for recapitalizing the banking system.

Why the hurry to "fix" Slovenia's banking system when doing it right takes time?

A Reuters article on eurozone leaders pushing Slovenia to fix its banking raises an interesting question: why does it have to be done quickly when doing it right takes time?

Common sense says that there are three steps to fixing the banking system the right way:

1. Require the banks to provide on-going transparency so that market participants can assess their global asset, liability and off-balance sheet exposure details.
2. Based on this assessment, the true extent of the problem can be determined and the losses can be realized.
3. Determine how to rebuild the banks' book capital levels over the next several years.

It is common sense that transparency is needed so that there is no doubt that all of the bad debt hidden on and off the banks' balance sheets is recognized.

As Ireland, Greece, Portugal and Spain have shown, so long as the banks remain "black boxes", market participants will never believe that all the hidden bad debt hidden been recognized.

So long as there is this doubt about what is lurking on or off bank balance sheets, the banking system has not been truly fixed.

Putting ultra transparency in place takes time.

It is common sense that before fixing the banks, the true extent of their bad debt needs to be known.  It is only when the size of the problem is known that the solution for fixing the banks that corresponds to the size of the problem can be chosen.

It will take time for market participants to assess the value of each of the banks' exposures.

Finally, it is common sense that the banks do not need to be recapitalized immediately.  Savers and SMEs, who represent the banks' core depositors, are using the banks today even though they know the banks probably have low or negative book capital levels when adjusted for all the hidden losses on and off their balance sheets.

Recognizing the hidden losses and putting the banks on a path towards recapitalization is not going to make the savers and SMEs stop using the banks.  If anything, it should make them more comfortable using the banks.

Recapitalizing the banks through retention of future bank earnings takes time.

So, why the hurry?

European banks need to be recapitalized when?

In his Financial Times column, Jean Pisani-Ferry asserts that European banks need to be recapitalized now.

Why recapitalize now?

Europe also made two mistakes in responding to the crisis. First, it failed to recognise the true extent of its banking problem. It believed – or pretended to believe – that the guarantees and recapitalisations of 2008-2009 had addressed the issue whereas weaknesses were in fact much more widespread. Second, it failed to appreciate that excessive private-sector debt was not just an American problem. In Europe too many households and companies needed to deleverage....

The first priority is financial repair. Banks with weak balance sheets lend on too expensive terms or lend to insolvent borrowers to keep them afloat and do not grant credit to new firms. This prevents profitable investment and the growth of new, more efficient firms.

A comprehensive bank balance sheet assessment is needed....

The first priority should be a comprehensive bank balance sheet assessment and this can only by accomplished by requiring the banks to provide ultra transparency.  With on-going disclosure of their current asset, liability and off-balance sheet exposure details, market participants can assess each of the exposures.

Market participants can then exert discipline so that banks recognize their losses on the excess debt in the financial system.  This market discipline ends the practice of lending to insolvent borrowers to keep them afloat.

This market discipline also rewards banks for making new loans to borrowers who can afford to repay the loans.

The ECB should not and will not accept undercapitalised – let alone insolvent – banks to fall under the common supervision. 

With this statement, Mr. Pisani-Ferry moves into the world of theory.  He assumes there are solvent banks in Europe.

In the real world, there is no such thing as a European bank that is not insolvent under the traditional definition of insolvency (the market value of its assets is less than the book value of its liabilities).  Supporting evidence for my statement comes from the need to nationalize several European banks that had passed the stress tests (for example, Dexia).

Mr. Pisani-Ferry also asserts that the ECB should not accept undercapitalized or insolvent banks.

As I discussed in a previous blog, were Walter Bagehot, who wrote the book on modern central banking, alive today he would recognize the existence of deposit insurance. This recognition would change his definition of bank solvency and result in the central bank acting as lender of last resort to banks with substantial negative book capital levels.

Mr. Bagehot would recognize that a bank that does not qualify for access to central bank funds is a bank where its interest income is not greater than its interest expense plus pre-banker bonus operating costs.

National authorities therefore have to initiate a recapitalisation of undercapitalised banks and a resolution of the insolvent ones. The moment is now. 

I agree that the moment for cleaning up the banking system is now.

Using the income driven approach to bank solvency, clearly those banks that are insolvent need to be resolved.

Using the income driven approach to bank solvency, those banks that are solvent should be required to retain 100% of their pre-banker bonus earnings until such time as they have rebuilt their book capital levels to regulatory standards.

While this may take years, it is not a problem as banks can continue to make loans to support the real economy.

How quickly do banks need to be recapitalized after recognizing losses?

How policymakers respond to a bank solvency led financial crisis is driven by how they answer the question: how quickly do banks need to be recapitalized after they recognize their losses on the excess debt in the financial system.

Your humble blogger's response is that banks do not need to be immediately recapitalized.  Instead, banks can rebuild their book capital levels over several years by retaining 100% of their pre-banker bonus earnings.

This is not the response that the global policymakers or financial regulators would give.  Nor is it the response that almost every economists would give, particularly those who are calling for banks to hold more capital.

The fact that I am in the minority in how I responded to this question puts the onus on me to show why I am right.

To show this, we need to start with a solvent, opaque bank.  The traditional definition of a solvent bank, which comes from the Financial Crisis Inquiry Commission, is the market value of its assets is greater than the book value of its liabilities.

           Assets
                 Cash                           5
                 Bonds
                    Government          10
                    AAA-rated            15
                 Loans                    
                    Performing            70
                   Non-performing       0
           Total Assets                 100

            Liabilities & Equity
                Core Deposits           70
                Hot Money deposits  20
                Equity                       10
            Total Liab. & Equity   100

Not only is this bank solvent, but it has terrific capital ratios.  It shows a simple equity to asset ratio of 10%.  Its Basel I, II or III capital ratios are even better.

Unfortunately, it turns out that this opaque, solvent bank was heavily exposed to subprime mortgages, commercial real estate and other areas of the financial system that collapsed at the beginning of our financial crisis.  The effects on this bank of marking all of its assets to market are shown below [AAA-rated bonds suffer loss of 10; loans suffer loss of 10; equity absorbs loss on bonds and loans and declines by 20].


            Assets
                 Cash                           5
                 Bonds
                    Government          10
                    AAA-rated             5
                 Loans                    
                    Performing            45
                   Non-performing     15
           Total Assets                   80

            Liabilities & Equity
                Core Deposits           70
                Hot Money deposits  20
                Equity                      (10)
            Total Liab. & Equity     80


Clearly, this banks is insolvent as the market value of its assets (80) is less than the book value of its liabilities (90).

Please recall that this bank is also opaque.  It provides the required disclosures that the Bank of England's Andrew Haldane would say results in its being like all the other banks, a 'black box'.

Naturally, this opacity is very important as it gives policymakers and financial regulators a choice:  make the bank publicly acknowledge and absorb its losses upfront or allow the bank to hide the true extent of its losses and slowly absorb them into earnings over the course of time.

Please note that regardless of which choice is made the bank is still insolvent under the traditional definition.

What the choice comes down to is when do the bank's financial statements reflect its true condition.  Now or at some point in time in the distant future.

If the financial regulators want to hide the true extent of the bank's losses, they can suspend mark to market and adopt mark to model accounting for its securities.  The financial regulators can also engage in regulatory forbearance and let banks practice 'extend and pretend' to turn non-performing loans into 'zombie' loans.

Both of these were done by global policymakers and financial regulators in response to our current financial crisis.

The impact of these actions is shown below for our now insolvent, opaque bank.


           Assets
                 Cash                           5
                 Bonds
                    Government          10
                    AAA-rated            14
                 Loans                    
                    Performing            65
                   Non-performing       4
           Total Assets                   98

            Liabilities & Equity
                Core Deposits           70
                Hot Money deposits  20
                Equity                         8
            Total Liab. & Equity     98

Please note that the bank's book capital, which is an accounting construct, no longer reflects the true condition of the bank (it is a positive 8 when the bank's true condition shows minus 10).

As Sheila Bair would say: as a result of measurement errors, this bank's capital is deceptive.  It doesn't present an accurate picture of the bank's risk or solvency.

Before going on, let me summarize three key points.

• First, the bank is insolvent under the traditional definition of solvency regardless of what its financial statements show.  

• Second, by fiddling with the accounting, policymakers and financial regulators are explicitly agreeing with me that a bank can operate and support the real economy even when it is insolvent under the traditional definition.

• Third, by fiddling with the accounting, policymakers and financial regulators are explicitly agreeing with me that a bank that is currently insolvent under the traditional definition can generate and retain enough earnings so that it becomes solvent again.

So, why do global policymakers and financial regulators engage in hiding bank insolvency?

The answer to this question is driven by their answer to how quickly banks need to be recapitalized after recognizing losses.  They assert that banks need to be recapitalized as soon as possible after recognizing losses.

Why?

Because a bank that shows low or negative book capital levels is prone to bank runs or it is hampered in its ability to support the real economy.

Let me address bank runs first.

Why should this bank be any more susceptible to bank runs after it reveals the true extent of its losses than it is when the losses are being hidden?  Do global policymakers and financial regulators think that market participants missed the implosion of subprime securities, commercial real estate and other areas of the financial system?

What market participants don't know is the exact extent of the losses suffered by each bank.  Market participants are keenly aware of the fact that each bank suffered extensive losses.  Losses that if fully recognized upfront may in fact leave the bank with substantial negative book capital levels.

So why aren't depositors fleeing the banks?  Deposit guarantees and access to central bank funding.

I break depositors into two groups: core and hot money.

Core depositors like individuals and SMEs have a long-term relationship with their bank.  They trust that even highly indebted governments will honor their deposit guarantees and protect them from any losses due to bank insolvency.  As Cyprus shows, hurting the SMEs devastates the economy so policymakers and financial regulators have a strong incentive not to do this.

As a result, core depositors don't care and probably couldn't tell you what the book capital level for their bank was at the end of last quarter.  They are with their bank for the long haul.

This is a key point because it is these depositors that are the key to the viability of the banking franchise.  It is their business that allows a bank to generate and retain the earnings that rebuild its book capital level and restore it to solvency over many years.

Hot money depositors are, as their name implies, only dealing with the bank as an investor.  At the first sign of problems and clearly this bank has problems, they are gone as soon as they can get their money out.

This group is in fact already engaged in a bank run.  A run that is slowed down to a jog by having their money tied up in time deposits.

So what does the bank look like after all of its hot money depositors have left?

            Assets
                 Cash                                   5
                 Bonds
                    Government                  10
                    AAA-rated                      5
                 Loans                    
                    Performing                    45
                   Non-performing             15
           Total Assets                           80

            Liabilities & Equity
                Funds from central banks  20
                Core Deposits                   70
                Hot Money deposits           0
                Equity                             (10)
            Total Liab. & Equity           80

Please note that under Walter Bagehot's principle for central banks acting as lender of last resort, central banks are suppose to lend freely against good collateral.  In this example, good collateral at 60 is 3 times greater than the size of the loan from the central bank.  So a bank run by hot money depositors is not a problem.

This example is all well and good, however, in the EU, the ECB is restricted to only lending to solvent banks.

Let's not kid ourselves.  The fact is that all the large banks in the EU, UK and US are insolvent whether their financial statements show it or not.

First, a bank that was not insolvent would provide ultra transparency to show it.  By disclosing its current global asset, liability and off-balance sheet exposure details, the bank is saying it has nothing to hide.  This would give it an enormous competitive advantage in both access to and lower cost of funds over other large banks that don't make a similar level of disclosure.

Banks that don't provide ultra transparency are announcing they have something to hide and are far riskier.

Second, the existence of deposit guarantees would change Walter Bagehot's definition of solvency.  It would no longer be solvency as defined by the Financial Crisis Inquiry Commission.  It would be adjusted for the existence of the deposit guarantee standing behind the core depositors.

The deposit guarantee implies a far higher level of "capital".  One way to reflect this is to subtract the guaranteed deposits from the solvency equation.  A bank is solvent if the market value of its assets exceeds the book value of its liabilities less guaranteed deposits.

In our example, our insolvent bank under the traditional definition of solvency is solvent after adjusting for the deposit guarantee [80 - (90 - 70) = 60].

This is very important.  As regular readers know, the time to resolve a bank is when the interest income from its performing assets does not exceed the combination of its interest expense and its pre-banker bonus cost of operations.

Please note, the ECB is already effectively using my modified definition of bank solvency and lending to banks that would be insolvent under the Financial Crisis Inquiry Commission's solvency definition under its promise to do whatever it takes.  There is no reason to believe that the ECB is fooled by EU policymakers and financial regulators playing games with the banks' financial statements.

Let me now address the issue of recognizing the losses would hurt the banks' ability to support the real economy.

Why?

As shown in the example, there is no reduction in the bank's ability to fund new loans after it absorbs its losses.  Cash didn't change.

Recognizing the losses actually improves a bank's ability to make loans.  As shown by Iceland, when the banks recognize upfront the losses on all the excess debt in the financial system, collateral values adjust to a sustainable level.  This is important as banks are senior secured lenders.

What limits the ability of banks to make new loans is an artificial construct:  regulators and their obsession with easily manipulated book capital.

Quite simply, it is not access to funding that hurts a bank's ability to fund new loans and support the real economy as it is the constraint on making new loans that the regulators force on the banks in the form of capital ratios.

It is the bank regulators who insist on a positive capital ratio even when the bank should be showing a negative book capital level.

Slovenia looks at how to rebuild its banking system

A Bloomberg article discusses how Slovenia needs to rebuild its banking system and the question of whether it needs outside resources to do so.

Regular readers know that the starting point for rebuilding a banking system is transparency.

It is only by having Slovenia's banks disclose their exposure details that the process of rebuilding can credibly begin.  Your humble blogger says this because without exposure detail disclosure, there is no way for market participants to know if each bank has recognized all of its losses or if it is still hiding losses.

Once each bank has recognized its losses, the question that must be asked is:  does the interest income on the bank's assets exceed the sum of the interest expense on its liabilities and its operating expenses pre-banker bonuses.

• If yes, the bank is capable of rebuilding its book capital levels and nothing more needs to be done.

• If no, the bank is not capable of rebuilding its book capital levels and should be shut down.

With this simple plan, Slovenia should be able to rebuild its banking system and, because of ongoing transparency into each bank's exposure details, prevent a similar problem from recurring.

Jazbec needs to restore public confidence at home and investors’ faith abroad in Slovenia’s banks as the economy struggles with its second recession since 2009, sparking a rash of corporate bankruptcies that have saddled lenders with a pile of bad debts. 

“The problems aren’t insurmountable,” Jazbec, who helped set up Kosovo’s central bank, said in an interview late yesterday. 

“We know we have to rebuild the banking system. With a common effort from all policy makers we can carry this through to ensure that assistance from outside the country won’t be needed.”

By making use of future bank earnings and transparency, Mr. Jazbec is likely to be proved right.

Draghi: EU needs bank-loss rules ASAP

As reported by Bloomberg, the ECB's Mario Draghi would like to see the EU adopt rules for dealing with insolvent banks as soon as possible.

In an earlier post, I laid out what the rules should be and the need for banks to provide ultra transparency so that the rules could be enforced without triggering a bank run in any part of the EU.

Your  humble blogger would suggest the following hierarchy for apportioning the pain of recapitalizing the bank or absorbing the losses.

1. Future earnings generated by the bank;  
2. Common stock holders;  
3. Preferred stock holders; 
4. Junior unsecured bondholders; 
5. Senior bondholders; 
6. Uninsured depositors; 
7. Host country taxpayers through the deposit guarantee;  
8. Foreign taxpayers.

What distinguishes this hierarchy is that it explicitly recognizes that a bank can transition between solvency and insolvency and back to solvency as the market value of its assets changes between greater than to less than to greater than the book value of its liabilities. 

As I describe in an earlier post explaining why a bank never needs to be bailed out, we can determine if a bank has a viable franchise by looking at whether its assets after recognizing its losses on its excess debt exposures generate enough interest income to exceed the interest expense on its liabilities.   

If interest income exceeds interest expense, the bank franchise is viable and the bank can generate the earnings to rebuild its book capital levels.  If interest income is less than interest expense, the bank should be resolved.  It is only then that we go past step 1 in the hierarchy. 

Naturally, bankers are going to fight against adoption of this hierarchy.  The reason they will fight adoption is that it puts the pain for the losses currently hidden on and off the bank balance sheets directly on the bankers. 

Specifically, while a bank is generating earnings to absorb the losses, banker pay is likely to be highly restricted.  As oppose to the current situation where taxpayers are absorbing the losses and bankers are paying themselves near record levels of pay. 

Of course, from the standpoint of everyone lower down in the hierarchy, including taxpayers, they prefer to maximize the amount of future earnings generated by the bank that are used to absorb the losses. 

This preference for maximizing future earnings to absorb losses highlights a critical issue:  how quickly do banks need to be recapitalized after they become insolvent? 

A modern banking system is designed so that banks can operate for years, even decades, with low or negative book capital levels.   

Banks can operate and support the real economy as a result of the combination of deposit guarantees and access to central bank funding.  With deposit guarantees, taxpayers effectively become the banks' silent equity partner when the banks are in the process of generating earnings to rebuild their book capital levels.  

Regular readers know that to prevent bankers gambling on redemption to restart their bonuses sooner and to ensure that banks absorb all the losses on the excess debt in the financial system, banks must provide ultra transparency.   

With disclosure of the banks' current global asset, liability and off-balance sheet exposure details, market participants can exert discipline on the banks to clean-up their exposures and restrain their risk taking. 

But what about the fact that banks are going to have negative or low levels of book capital? 

It is the deposit guarantee that makes bank book capital levels irrelevant to insured depositors.  A lesson learned from their parents when they opened up their first bank account as a child and asked how could they trust that the bank would give them their money back. 

Yes, uninsured depositors, bondholders and stockholders are going to be concerned about the level of book capital.  The low level is a source of market discipline as it gives them a vested interest in making sure that banks minimize their risk while rebuilding book capital levels.