Are European policymakers about to trigger EU-wide bank run

Reuters reports that EU policymakers are looking at making bank depositors bear some of the cost of bailing out the banks in Cyprus.

Once established, this policy will apply to banks in Spain, Italy, France ... and the EU-wide run on the banks will be on as a) no one can tell if any EU bank is solvent and b) there is plenty of anecdotal evidence that none of the EU banks is solvent.

European policymakers are split over how to handle a bailout of Cyprus, with Germany and some other countries pushing for bank depositors to bear part of the cost and many other member states worried such a move will cause a bank run. 

Euro zone officials say momentum has built in recent days behind the idea of "bailing-in" Cypriot bank shareholders and depositors, although the specifics of how such an operation would be carried out have not been pinned down....

Germany, Finland and the Netherlands are among those who say taxpayers cannot be expected to go on financing euro zone bailouts, saying it is time for owners and depositors in risk-laden banks to accept losses on investments. 

The concern is that announcing such a move will provoke the immediate, large-scale withdrawal of deposits from all Cypriot banks, where a large number of international investors, including many Russian and British companies, hold accounts....

While Cyprus is the euro zone's third smallest economy with annual GDP of only around 18 billion euros, a bank run could have repercussions across the single currency bloc and re-ignite the debt crisis, officials warn. 

"We have to consider that risk," said one euro zone officials whose country is undecided about whether a bail-in of depositors is the right course of action. "It's a real option but some countries don't want it."

I happen to agree that unsecured bank debt and equity holders should bear losses.

However, the necessary condition for these investors to hold losses is that the banks provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

With this information, investors can assess the risk and solvency of a bank and can adjust both the amount and price of their exposure to a bank to reflect this assessment.  As a result of having the information on which to make an informed investment decision, the investor is responsible for all losses on their exposure.

Unfortunately, this is not the case.  As the Bank of England's Andrew Haldane says, current bank disclosure leaves them resembling 'black boxes'.

If they were only black boxes, then losses could be imposed on the gamblers who buy the unsecured debt and equity of these black boxes.

Banks are not just black boxes.  Banks are black boxes where the bank regulators have been making public comments about the content of these black boxes.  Specifically, bank regulators have been saying that they are solvent.

Oops.  How can you impose a solvency related loss on an investor who relied on the bank regulators' statements that the bank was solvent?

The simple solution is to realize that banks are designed to operate with low or negative book capital levels and to not bail out the banks.

By requiring the banks to provide ultra transparence, the market can exert discipline so that the bankers do not gamble on redemption as they retain future earnings to rebuild their book capital levels.

In defending Geithner's bank bailouts, Roger Lowenstein cites modern bank run

In his Bloomberg column defending the Geithner led bailouts of the banks, Roger Lowenstein said they were necessary as the banks were experience the modern version of a bank run.  More importantly, Mr. Lowenstein notes that deposit insurance was adopted to prevent an old-fashion bank run, but virtually nothing has been done to address the modern version.

We know what happened in 2008: Wall Street was struck by a modern-style bank run. Yet most of the regulatory response hasn’t been concerned with deterring another panic. 

The Dodd- Frank financial-reform law and other measures are mostly about making sure that banks don’t do something stupid, such as operate with too little capital, or trade derivatives without transparency. These are good and worthy goals. 

But at some point, if history is any guide, banks will discover some new, supposedly foolproof, asset class and become too exposed to it. It won’t be tulips; it won’t be subprime mortgages; it will be something we can’t anticipate now. And when this new “sure thing” starts to look dicey, banks will be vulnerable again.

Actually, it was not simply that banks became too exposed to a supposedly foolproof asset class that was the problem.

The problem was and still is that banks are 'black boxes'.

As a result, market participants, including other banks, had no way of knowing which banks were solvent and which banks were not (this conclusion appears in the Financial Crisis Inquiry Commission report).

When a lender doesn't know if the borrower is solvent or not, they don't make a loan.  This has been confirmed for the last 5 years by the simple fact that the interbank lending market remains frozen.

Although Congress mostly avoided the issue after 2008, we do have experience in deterring panics. 

Regulations tend to focus on what banks own (assets such as loans and securities). Avoiding panics is concerned with what they owe (liabilities, which include deposits).

Actually, there is no reason to believe that the institutions involved with the bank liabilities panicked.

In fact, all the evidence points to them behaving in a very rational manner.  Since they could not determine if the borrowing bank was solvent or not and therefore capable of repaying their loans, they chose not to roll-over their loans.

After the bank runs of the early 1930s, the U.S. enacted deposit insurance. And since then, customers haven’t run to the bank, even if the bank is thought to be unsound. 

This poses a moral hazard: What if banks, realizing their deposits are insured, recklessly gamble on unsound assets? 

This happened in the savings-and-loan crisis in the 1980s, and it was expensive....

This is why there is a need for banks to 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, including regulators, can exert discipline so that bankers don't  'gamble on redemption' (which was what drove up the cost of the savings-and-loan crisis).

We did have bank runs in 2008, though not the kind seen in the old photographs with men in hats and coats lined up on the sidewalk. 

Instead of ordinary depositors, the people who pulled their money out were investors in various unregulated instruments such as repurchase-agreement loans, short-term commercial paper and money-market funds. 

Each of these is similar, in an economic sense, to a deposit: They offer people and institutions a place to park savings with seeming security and the option of immediate withdrawal. 

During the financial crisis, it was these “depositors” who panicked....

Again, I disagree with Mr. Lowenstein that these investors panicked.  When you cannot tell if the bank you are lending to has the ability to repay the loan, you don't make the loan.

The difference between old- fashioned deposits and the so-called shadow-market loans described above is that the former can only be issued by banks and in certain well-defined circumstances. And banks must purchase deposit insurance. 

Shadow deposits are uninsured and mostly unregulated. 

The solution, as in the 1930s, is to regulate short-term IOUs and to require, in many cases, insurance. 

In broad terms, if you are a financial institution, you would be able to borrow short-term funds only under certain conditions and, when you did, you would need insurance. This would have a cost, just as deposit insurance has a cost....

Insurance is the wrong solution for this problem.  The right solution is to require banks to provide ultra transparency.

With ultra transparency, these investors can assess the risk and solvency of each bank.  As a result, these investors can adjust both the price and amount of their exposure based on the risk of the bank.

These investors have an incentive to assess the risk and adjust their exposure because they know that as a result of the banks providing ultra transparency the investors are responsible for all gains and losses on their bank exposures.

Unlike insurance which doesn't adjust to the increase risks that the banks take on, the cost of funds from investors who can assess the bank's risk because of ultra transparency does increase as more risk is taken on.  Unlike insurance, investors provide a restraint on bank risk taking.

Banks are likely to oppose such measures, which would cut into their profits. Recently, to the satisfaction of bankers, international regulators in Basel, Switzerland have actually loosened liquidity standards aimed at preventing a repeat of 2008.

As I have previously stated, one of the benefits of ultra transparency is that the market doesn't care what the banks think.  Knowing that they are at risk of loss, market participants independently assess the risk for themselves and act based on this independent assessment.

Morgan Ricks, a former Treasury senior policy adviser and now an assistant professor at Vanderbilt Law School, says the banks’ cheap overnight funding provides undeserved, “subsidy profits." 

Their borrowing costs, he says, are inordinately cheap because the market believes that banks won’t be allowed to fail. Insurance would put a price on that subsidy.

The subsidy would be ended by providing ultra transparency.  Insurance does not end the subsidy as there is no reason to think that deposit insurance is priced at a level that removes 'subsidy profits'.

Ricks says the regulatory response to the crisis “focused on the wrong stuff.” The first priority should be “the instability of the funding model.”

I agree and the only way to make the funding model stable is by requiring the banks to provide ultra transparency.

UK financial institution calls for full deposit insurance

Nationwide Building Society, a UK financial institution, answered the question of why was there a run on Northern Rock while calling for full deposit insurance.

As reported by the Telegraph, Nationwide would like full deposit insurance for all financial institutions so as to eliminate the confusion that triggered the run on Northern Rock.

The reason for the run was that Northern Rock depositors knew that their deposits were guaranteed up to a certain level, but were confused over what this level was.

Remember, with deposit insurance, depositors don't care about the performance of the bank.  They only care they can get their money back.

Nationwide Building Society has been lobbying for clearer and more comprehensive protection for depositors for over a year now, and is stepping up efforts ahead of publication of the new Financial Services Bill. 

Under current arrangements, savings are only insured up to a maximum of £85,000 per person per bank or building society. Above that, savers would face losses if the company failed. 

However, Graham Beale, Nationwide’s chief executive, told The Daily Telegraph: “[Protection] should apply to all deposits, not just those less than £85,000.” 

In 2007, confusion over the level of protection sparked the run that brought down Northern Rock, as depositors queued to withdraw their money until the Chancellor promised every penny would be backed by the taxpayer. 

Changes are now being made to the law to enshrine “depositor preference”, which will put insured deposits ahead of other bondholders in the creditor hierarchy to guarantee savers get £85,000 back within days of a bank’s collapse. 

However, Nationwide, the UK’s second largest savings provider with £125bn in deposits, wants the law extended to cover all retail savings to avoid confusion. “The consumer message of full depositor preference is much more powerful and comprehensible,” Mr Beale said.

 Full depositor protection is now implicit based on the government's action in 2007.

The mutual is backed by the Building Societies Association but its position sets it against the banking industry, which does not even back “depositor preference” for the first £85,000. 

Banks claim the £85,000 is protected by the industry insurance scheme so there is no need for a complex legal change that puts other creditors more at risk and may consequently push up banks’ costs. 

“Depositor preference gives customers no added protection and increases substantially the losses of other creditors,” the British Bankers’ Association said in its Parliamentary submission.

It is not surprising that UK banks do not want depositors to have preference.  They know that it is really the taxpayer that is guaranteeing the deposits.

For example, in the US, the FDIC has unlimited ability to draw from the US Treasury to cover losses on its deposit guarantee.

The lack of preference increases the potential for loss on the deposits with the benefit accruing to the other creditors and therefore to the bankers in terms of cheaper funding.  That is why in the US deposit insurance scheme the FDIC has preference over other creditors.

Deposit flight from peripheral country banks undermining euro

As reported by Bloomberg, the accelerating deposit flight from the banks in the peripheral Eurozone countries is undermining both the euro and the idea of eurozone financial integration.

The retreat from financial integration has been encouraged by bank regulators.

For example, the UK Financial Policy Committee asked UK banks to lower their exposure to a break-up of the eurozone.  As a consequence, banks have either reduced their exposures to the eurozone or tried to match fund their assets in a country with deposits from that country.

Regular readers know that this policy encouragement is just a continuation of the Japanese model for handling a bank solvency led financial crisis under which bank book capital levels are protected at all costs.

It is the pursuit of the Japanese model that is triggering the problem.

Specifically, in protecting the French, German and UK banks from taking losses, the Eurozone policymakers  have managed to a) socialize the losses and put them onto taxpayers, b) inflict significant damage to the real economies of the peripheral countries and c) trigger bank runs in the peripheral countries.

All of these 'achievements' could have been avoided if policymakers had not chosen to protect bank book capital levels and by extension banker bonuses at all costs.

As shown by Iceland, by making the banks absorb the losses, damage to the real economy is minimal.

An accelerating flight of deposits from banks in four European countries is jeopardizing the renewal of economic growth and undermining a main tenet of the common currency: an integrated financial system. 

A total of 326 billion euros ($425 billion) was pulled from banks in Spain, Portugal, Ireland and Greece in the 12 months ended July 31, according to data compiled by Bloomberg. The plight of Irish and Greek lenders, which were bleeding cash in 2010, spread to Spain and Portugal last year. 

The flight of deposits from the four countries coincides with an increase of about 300 billion euros at lenders in seven nations considered the core of the euro zone, including Germany and France, almost matching the outflow. That’s leading to a fragmentation of credit and a two-tiered banking system blocking economic recovery and blunting European Central Bank policy in the third year of a sovereign-debt crisis. 

“Capital flight is leading to the disintegration of the euro zone and divergence between the periphery and the core,” said Alberto Gallo, the London-based head of European credit research at Royal Bank of Scotland Group Plc. “Companies pay 1 to 2 percentage points more to borrow in the periphery. You can’t get growth to resume with such divergence.”

The erosion of deposits is forcing banks in those countries to pay more to retain them -- as much as 5 percent in Greece. The higher funding costs are reflected in lending rates to companies and consumers. .... 

The ECB has taken the place of depositors and other creditors who have pulled money out over the past two years, largely through its longer-term refinancing operation, known as LTRO. 

The Frankfurt-based central bank was providing 820 billion euros to lenders in the five countries at the end of July, data compiled by Bloomberg show. Irish and Greek central banks loaned an additional 148 billion euros to firms that couldn’t come up with enough collateral to meet ECB requirements. 

Because central-bank financing is counted as a deposit from another financial institution, the official data mask some of the deterioration. Subtracting those amounts reveals a bigger flight from Spain, Ireland, Portugal and Greece. For Italian banks, what appears as a 10 percent increase is actually a decrease of less than 1 percent. 

When financing by central banks isn’t counted, the data show that Greek deposits declined by 42 billion euros, or 19 percent, in the 12 months through July. Spanish savings dropped 224 billion euros, or 10 percent; Ireland’s 37 billion, or 9 percent; Portugal’s 22 billion, or 8 percent.

The pace of withdrawals has increased this year. 

Spanish bank deposits fell 7 percent from the beginning of January through the end of July, compared with a 4 percent drop the previous six months. The decline in Portuguese savings accelerated to 6 percent from 1 percent, while Irish deposits fell 10 percent compared with almost no change in the last six months of 2011....

ECB cash may have plugged holes at lenders that otherwise would have had to sell assets at fire-sale prices as they lost private financing. The aid didn’t prevent funding costs from rising for the rest of the banks’ borrowing, including deposits....

Another blow to financial integration is the localization of borrowing and lending. 

Units of German, French and Dutch banks in Spain, Italy and other peripheral countries also borrowed from the ECB to reduce the need for funds from their parent companies. Deutsche Bank AG, Germany’s largest bank, said last week it had cut the reliance of units on financing by the Frankfurt-based firm 87 percent through ECB loans. 

While the largest banks say they’re protecting themselves against currency redenomination in case a country leaves the union, such moves help exacerbate divisions between the periphery and the core. A locally financed Deutsche Bank unit can’t make loans that reflect the cheaper funding sources of its parent in Germany.

By taking over the financing of weak banks, the ECB is in effect bailing out their creditors in the core, according to Edward Harrison, an analyst at Global Macro Advisors, an economic consulting firm in Bethesda, Maryland. 

If Irish or Spanish lenders burdened with losses from their nations’ housing busts were allowed to fail, German and French banks would lose money on loans to financial institutions in Europe’s periphery. 

The ECB’s latest plan to buy the sovereign bonds of some countries will continue the trend of bailing out German and French banks, Harrison said. 

“The leaders of the core countries won’t let the periphery countries write down their debt because then they’d have to capitalize their own banks losing money from those investments,” Harrison said. “This is a good backdoor bailout of their banks, but it still doesn’t solve the solvency issue of Spain or Italy.” 

The rescue shifts default risk from private shareholders of core banks to the ECB and, in effect, to euro-area taxpayers.....

Run on Spanish banks picking up speed

In a vote of no confidence, Spanish depositors are taking their money out of the Spanish banking system.

As predicted by your humble blogger, the policies being pursued both at the national level and at the EU level are undermining confidence in the Spanish banking system.  Rather than requiring the banks to absorb all the losses on the excess debt in the financial system, policies are being pursued that make the situation worse.

For example, bailing out the banks promises to pile more debt upon a country that cannot pay the debt it already has and to further burden the already failing Spanish real economy as austerity measures are implemented that divert taxes to debt service and not government services.

Clearly the Spanish depositors have gotten the message that Spain could exit the EU and the state's deposit guarantee might be honored in pesetas and not euros.  This result of this redenomination would be a considerable loss for the depositors.

As reported by Bloomberg,

Spanish banks, already hooked on cheap European Central Bank loans, are haemorrhaging deposits as the government debates whether to seek a bailout. 

Households and companies drained 26 billion euros ($34 billion) from Spanish bank accounts in July, driving the ratio of loans to deposits among lenders to 187 percent from 183 percent in December and 182 percent a year earlier, according to data compiled by the Bank of Spain. 

Shrinking deposits undermine the ability of banks to support economic growth by lending to companies and consumers. 

“There are significant outflows of deposits now in Spain and they won’t start coming back until people are sure they’re safe and that Spain is secure,” said Simon Maughan, a financial strategist at Olivetree Securities Ltd. in London. 

Spain’s financial industry is already backstopped by Europe to the tune of 100 billion euros, and is reliant on 412 billion euros of gross borrowings from the ECB. Investors demand 423 basis points more to own CaixaBank SA bonds maturing in 2015 than German bunds of similar maturity, up from a premium of about 384 when the bonds were sold in January..... 

Moreover, the terms of Portugal’s May 2011 bailout require its banks to achieve a loan- to-deposit ratio of 120 percent by the end of 2014, while Ireland’s deal demands a ratio of 122.5 percent by 2013. No such provision was included in the July memorandum of understanding for Spain’s bank bailout. 

“The first consequence of a lower loan-to-deposit ratio being set is that you have to identify chunks of assets to sell and that inevitably leads to haircuts and capital implications,” said Eamonn Hughes, an analyst at Dublin-based Goodbody Securities. “It also forces you to pay up for deposits, as we have seen in the Irish case.” 

Imposing a loan-to-deposit target for Spanish lenders may mean they would have to reduce lending by 14 percent to 24 percent, Daragh Quinn and Duncan Farr, analysts Nomura International, wrote in a report published today. “The need to strengthen customer funding could also see the emergence of a deposit war, putting additional pressure on revenues, which are already likely to suffer from the low interest rate environment,” they said.... 

There is “a clear underlying trend of accelerating deposit decline,” Nomura’s Quinn wrote in a Sept. 4 report. Term deposits by households fell 6.9 percent in July from a year earlier, while those of companies fell 24 percent, which “points to continued deposit declines in the future,” he said....

About 86 percent of Bankinter SA (BKT)’s estimated 2013 profits derive from its ability to borrow cheaply from the ECB, the analysts said, with Banco Popular Espanol SA dependent on central bank funds for about 79 percent of earnings. 

These figures give some sense of how large the impact on bank earnings is from the extraordinary measures that policymakers are pursuing.

What this figures don't show is that bankers are being paid bonuses on these profits.  Think about that.

In the absence of the extraordinary measures like cheap ECB borrowing, the bankers would have received little in the way of a bonus.

Is there any wonder that bankers are constantly saying that they need these extraordinary measures?

Meanwhile, Bank of Spain data shows lenders are offering higher deposit rates to attract cash, with interest rates on account for as long as one year climbing to 2.5 percent in July, the highest level since March. 

Declining deposits may inflict more damage on the Spanish economy if the seepage of the most reliable source of funding further dries up credit, said Maughan at Olivetree. The International Monetary Fund predicts Spain’s economy will contract 1.7 percent this year and 1.2 percent in 2013. 

“If deposits are falling, then the only option for Spanish banks to bring down their loans to deposit ratio is to cut back on the loans side,” Maughan said. “Does that sound like a good idea?”

Spain banking crisis looks like it might be spiraling out of control

As predicted by your humble blogger, by pursuing strategies that did not credibly address the bad loans in its banking system, the Spanish government finds itself with a banking crisis that looks like it might be spiraling out of control.

As reported by Ambrose Evans-Pritchard in the Telegraph,

The country’s finances are unravelling on every front, with internal rescues for Catalonia, Valencia, Murcia, and Andalucia fast depleting the €18bn fund set aside for the regions. 

It emerged today that Spain’s social security system has raided a rainy-day fund to cover state pensions for the first time as deepening recession erodes contributions. 

Tomas Burgos, social security minster, said the government had drained €4.4bn from the Fondo de Prevencion – financed from workers’ illness insurance – to the meet the shortfall in July, reducing the account to just €400m. 

Mr Burgos said Madrid may have to use “all mechanisms at our disposal” to meet payments, revealing that the next step may be a raid on the pension system’s €67bn Reserve Fund. The pension system has been losing contributors as unemployment soars to 25pc. It shed a further 137,000 jobs in August. 

Meanwhile, official data shows that the toxic property loans of Spain’s four nationalised banks have reached €75bn and are rising faster than feared. Bankia’s “potentially problematic” loans are €42bn. The biggest surprise is a 50pc surge in bad debts to €9bn at Cataluyna Caixa since January. Non-payments on mortgages have doubled. 

Nomura’s Jens Nordvig said Spain’s crisis has entered a “more dangerous phase”, resembling the sort of currency dramas once confined to emerging markets. 

Capital flight has been running at an annual rate of 50pc of GDP, more than twice the rate in Indonesia during the Asian meltdown in the 1990s. 

Foreigners have sold Spanish securities worth 19pc of GDP over the past quarter. Spanish residents have shipped funds worth 16.7pc of GDP into foreign bank accounts. 

Net claims on Spain through the ECB’s Target 2 payments system have reached 39pc of GDP. 

“The build-up in central bank liabilities is explosive,” said Mr Nordvik.

With its finances unraveling and its banks sitting on an unknown pile of losses, it is no surprise that depositors are racing to withdraw their money and move it to other banking systems that are perceived to be safer.

Given the threat to kick Greece out of the EU, the depositors have every reason to be concerned with having their savings converted into pesetas that are far less valuable.

As reported by the Wall Street Journal, Spain is looking to the ECB to fill the funding void left by the deposits being transferred out of the Spanish banking system.

Nearly three months after Spain requested a €100 billion ($126 billion) European bailout for its banks, the problems facing the country's frail banking system are deepening, putting pressure on the European Central Bank to take action this week....

But the very storm that drove investors away from Spain—the deterioration of its banking system—appears to be gathering force. The latest trouble is the inability of Spanish banks to finance themselves through usual means. 

Capital markets remain largely shut because investors refuse to buy bank bonds at affordable prices. And customers, nervous about the banks' health, are increasingly yanking their deposits. 

The reason that Spain's banks cannot tap the capital markets is because they are opaque black boxes and no one can figure out what losses are hidden on and off their balance sheets.  If investors cannot figure out the risk of investing, they demand a sizable risk premium to be compensated for the unknown risk.

The banks appear to be exhausting their capacities to wring cash out of the European Central Bank, the lender of last resort for much of Southern Europe's battered financial system.

The banks are exhausting their capacity because they are running out of collateral to pledge.

The problems have been building since last fall. But the recent intensification has sent Spanish officials scrambling to prevent their banking system's liquidity problems from escalating into an acute financial crisis....

It is the liquidity crisis spawned by the run on the banks that historically causes the banking system to collapse.

In one sign of the mounting pressures, the Bank of Spain appears to have started providing emergency loans to some of the country's banks, according to central-bank data and industry officials.

Ireland also provided emergency liquidity assistance.  This occurs when the banks have effectively run out of good collateral to pledge to the ECB and are left pledging assets that the ECB is unwilling to accept as collateral.

Under the emergency liquidity assistance program, the Spanish government is using its guarantee to get money from the EC.

The Spanish government offered another relief measure last week by scrapping a regulation that essentially put a ceiling on the interest rates banks can dangle in front of depositors—a rule introduced last summer to defuse an escalating and potentially destabilizing price war among banks. 

The banks quickly responded by jacking interest rates above 4% in a bid to woo skittish customers. 

They are trying to slow a parade of customers pulling money out of bank accounts. 

Deposits dropped 4.7% in July to €1.51 trillion, according to ECB data. The nearly €75 billion monthly decline was the sharpest in Spain since the ECB started tracking such information in 1997....

This raises the question of how large the deposit withdrawal were in August and in the first part of September.

"You have a liquidity crisis now," said Philippe Bodereau, head of European credit research at giant bond investor Pimco. "A bank 'jog' is happening in Spain. The private sector is leaving the banking system." 

Propelling the exodus are fears about the industry's health. 

Even after the Spanish government sought to erase the concerns in June by seeking a €100 billion loan to recapitalize the sector, customers and investors remain wary of losses lurking on the banks' books and the prospect that Spain eventually might leave the euro zone. 

It is the risk of having the deposits converted to less valuable pesetas that is the primary driver in the run on the Spanish banks.

Spain's banks have filled the void left by departing customers by turning to the ECB and Spain's central bank. 

At the end of July, the industry had borrowed a total of €410 billion from the ECB. The biggest borrowers range from relatively healthy institutions like Banco Santander SA to wards of the state such as Bankia SA. Four of the five biggest ECB borrowers hail from Spain, according to UBS analysts....

Spanish bank run reflects EU policy response

The New York Times ran an interesting article that documents how the EU policy response to the financial crisis has contributed to the Spanish bank run.

Regular readers know that modern banking systems are designed to prevent bank runs.  Bank runs are prevented by deposit guarantees and access to central bank funding.

The deposit guarantees remove individual bank solvency risk and replace it with the solvency risk of the state.  So long as depositors think the government will perform on their guarantee, deposits stay in the banking system.

Access to central bank funding is critical as it provides the liquidity that the banks need to ensure that depositors can withdraw their money.

While a modern banking system is designed to prevent bank runs, EU policymakers have pursued policies that undermine this design at every turn.

First, EU policymakers have bailed out the banks.  By bailing out the banks, the EU policymakers use up the state's capacity to borrow.  This casts doubt on the ability of the state to perform on the deposit guarantee.

Second, EU policymakers have threatened to kick Greece out of the EU.  This has introduced forced currency conversion risk.  The risk here is that the depositors euros will be converted into far less valuable drachma or pesetas.

Having undermined the design of Spain's banking system, it is no surprise that the EU policymakers have managed to trigger a bank run.

“The macro situation in Spain is getting worse and worse,” Mr. Vildosola, 38, said last week just hours before boarding a plane to London with his wife and two small children. “There is just too much risk. Spain is going to be next after Greece, and I just don’t want to end up holding devalued pesetas.” 

Mr. Vildosola is among many who worry that Spain’s economic tailspin could eventually force the country’s withdrawal from the euro and a return to its former currency, the peseta. That dire outcome is still considered a long shot, even if Spain might eventually require a Greek-style bailout. But there is no doubt that many of those in a position to do so are taking their money — and in some cases themselves — out of Spain. 

In July, Spaniards withdrew a record 75 billion euros, or $94 billion, from their banks — an amount equal to 7 percent of the country’s overall economic output — as doubts grew about the durability of Spain’s financial system.

The deposit outflow in Spain reflects a broader capital flight problem that is by far the most serious in the euro zone. .... 

“No doubt there is a little bit of panic,” said José García Montalvo, an economist at Pompeu Fabra University in Barcelona. “The wealthy people have already taken their money out. Now it’s the professionals and midrange people who are moving their money to Germany and London. The mood is very, very bad.”...

Setting off the flight was the failure of Bankia, which came as a shock to Spanish savers who had been assured by government officials that the bank was in good shape....

Under the FDR Framework, governments are never suppose to offer an opinion about the solvency of a bank.  Instead, governments are suppose to ensure that the market participants have access to all the useful, relevant information in an appropriate, timely manner to make a fully informed investment decision about the bank.

For banks, this information is ultra transparency and requires that banks provide ongoing disclosure of their current global asset, liability and off-balance sheet exposure details.

Still, as the examples of Mr. Vildosola and Mr. Pérez show, individual deposit flight is becoming more pronounced. 

Some people are willing to fly to London for the day just to open an account there, as most banks in the city require such transactions to be made in person. 

Spanish bankers working for British financial institutions say they have been hit with a barrage of questions about how to open savings accounts in London. 

“It seems as if everyone I know in Spain is getting on an easyJet to come to London and open a bank account,” said one such banker, who spoke on condition of anonymity, citing his company’s policy.

Bankia provides lesson in how to make a bad situation worse

Regular readers know that a modern bank is designed to continue in operation and support the real economy even if it has negative book capital levels.

The reason this is true is that through deposit insurance, the taxpayers are the bank's 'silent' equity partners.  So while the 'balance sheet' might show a negative number, effectively the taxpayers are filling the shortfall through the deposit guarantee.

For their part, the deposits are stable.  This stability is independent of the solvency of the bank and reflects a belief that the government will honor its deposit guarantee.

So what happened to Bankia over the first half of the year?

For those who might have forgotten, Bankia is the subject of a bailout by the Spanish government.

Complicating matters is the simple fact that Bankia sold equity investments to many of its depositors arguing that these investments were as safe as guaranteed deposits.  Now, it turns out, that these investments are going to lose money.

Further complicating matters is the simple fact that Spain does not have access to the financial resources to bailout Bankia.  It has turned to the EU.  The last country to do so was Greece.

So what are the implications of these complications for Bankia?

Since Spain is following in Greece's footsteps, the concern that depositors have is that their deposits might be revalued into a currency worth half as much as the euro.  Spanish depositors see the efforts that Germany is making to kick Greece out of eurozone and cause it to return to the drachma and they are justifiably worried that Spain will also be kicked out and forced to return to the peseta.

Rather than wait to see if that will happen, Spanish depositors are taking their money and sending it abroad.  Last month, almost 5% (74 billion out of 1.5 trillion euros) of the deposits in the Spanish banking system left the system.

Since many of the Bankia depositors feel that they were duped into buying the Bankia equity investment, there is also the additional incentive not to trust the Bankia or the authorities and pull one's deposits.

I cannot tell you whether it is fear of loss from currency conversion or distrust, but according to the Guardian,

Bankia posted a first half loss of €4.5bn. Private sector deposits fell by €12.8bn, while client funds fell a whopping €37.6bn...

This is not a bank jog, but rather a bank run that Bankia is experiencing.

Please note that this bank run reflects the fear of forced currency conversion and the mis-selling of equity securities.  Both of these were easily preventable.

Continuing to protect banker bonuses, Spain sets up bad bank to "buy" troubled assets

Once again, given its choice between its unemployed youth or preserving banker bonuses, Spain's government preserves banker bonuses.

The Spanish government is preserving bonuses by setting up a bad bank to purchase the 'bad assets' in the financial system.

A bad bank is nice in theory, but there are several insurmountable problems:

• What is a bad asset?  Is it a 'zombie' loan that the bank continues to keep current using 'extend and pretend'?  Or is it an asset that is so far gone that it is actually non-performing?  For example, is Spanish government debt a bad asset?
• What is the 'purchase' price for the bad asset?

Regular readers know that ultimately the only way to show that the banks have been cleaned up is to require the banks to provide ultra transparency and disclose all of their current global asset, liability and off-balance sheet exposure details.

This is the information that market participants need if they are to be able to independently confirm that the banks have been cleaned up.

Without ultra transparency, market participants will continue to assume that the banks are fully loaded with bad loans ... if they weren't, there is no reason not to provide ultra transparency and show it.

As reported in the Guardian,

Spain will inject emergency capital into the country's biggest ailing bank, Bankia, as it puts into place reforms to allow loss-making banks to receive eurozone bailout money....

Please recall that by design a modern banking system does not need the government to inject taxpayer funds into any banks.

Because of deposit insurance and access to central bank funding, a bank can continue to operate and support the real economy even when it has negative book capital levels.  It can do so since the deposit insurance effectively makes the taxpayer the 'silent' equity partner in the bank.

The Spanish government passed an ambitious banking law on Friday pledging once more that this would be the definitive shakeup for its finance sector that needs up to a €100bn (£80bn) bailout. 

"This brings reform of the finance system to its crowning point," the deputy prime minister, Soraya Saenz de Santamaría, said as the government presented its third reform in six months.

No chance this is true.  Like Greece, Spain's economy is spiraling downwards.

A so-called "bad bank" will swallow large amounts of the toxic real estate that has brought down several Spanish banks and threatens several more. The property is left over from the housing construction bubble that burst in 2008, just as the credit crunch happened, and which lies at the root of Spain's double-dip recession and 25% unemployment.

Ireland also tried a bad bank and all it succeeded in doing was undermining the financial capacity of the country.  The same is true of Spain.

The bad bank will receive building plots, unfinished developments and possibly tens of thousands of unsold homes from developers who went bust or are struggling to repay loans. It will be expected to sell this stock at a profit over the next 10 to 15 years. "It will be viable and will not post losses," the finance minister, Luis de Guindos, said.

No chance that it will be 'profitable' if the government were to receive a return that reflects the risk of the bad bank.

The creation of the bad bank – which the government hoped would be mostly privately financed – was one of the demands made by the eurozone countries providing the €100bn loan facility to Spain's banks....

Who would invest in the bad bank unless the government effectively guarantees their return?

De Guindos did not say what price the bad bank would pay for toxic assets, but promised a transparent system. This should be in place by December. 

"The reform is a step in the right direction, but there is still much to do," said Carlos Vergara, of the IESE business school, pointing to doubts about the price the bad bank will pay for toxic assets and the names of those banks that are not considered viable. 

"The key is at what price these assets are bought," agreed Jordi Fabregat of the Esade business school. "If it is too high, then the Spanish people will end up paying for it." 

De Guindos said the two rounds of provisioning ordered earlier this year should ease the process of setting a price as some of the worst assets, such as building land, are now provisioned at 80%. 

The worst assets may effectively be worth less than zero (think half built houses in the middle of nowheres).  An 80% write-down from original value still leaves the bad bank with a 100+% loss from its purchase price.

Spain's banks have an estimated €184bn in toxic real-estate loans and investments, but only some will go to the bad bank.

 If not all of the toxic debt goes into the bad bank, why have a bad bank at all?

Deposit flight from Spanish banks reaches new highs

As previously discussed and predicted by your humble blogger, deposit flight from the Spanish banking system continues to accelerate so long as the threat of deposits being converted to a less valuable currency hangs over depositors' heads.

The Telegraph reports that the Spanish banking system lost deposits equivalent to 7% of GDP or 74 billion euros last month.

Halting this deposit flight requires two policy changes.

First, the Spanish government must force the Spanish banks to absorb the losses on the excess debt in the Spanish financial system.  With the burden of the bad debt taken off of the Spanish economy, like Iceland's, the economy can resume growing and the possibility of needing to leave the EU recedes.

Second, the EU must use the bailout funds to backstop the Spanish deposit guarantee.  This increases the Spanish banks' access to central bank funding in euros and further reduces the threat of an involuntary conversion of deposit accounts to a less valuable currency.

Data from the European Central Bank shows that outflows from Spanish commercial banks reached €74bn (£59bn) in July, twice the previous monthly record. This brings the total deposit loss over the past year to 10.9pc, replicating the pattern seen in Greece as the crisis spread. 

It is unclear how much of the deposit loss is capital flight, either to German banks or other safe-haven assets such as London property. The Bank of Spain said the fall is distorted by the July effect of tax payments and by the expiry of securitised funds. 

Julian Callow from Barclays Capital said the deposit loss is €65bn even when adjusted for the season: “This is highly significant. Deposit outflows are clearly picking up and the balance sheet of the Spanish banking system is contracting.” 

Economy secretary Fernando Jimenez Latorre said Spain is in the eye of the storm right now with the “worst falls” in economic output yet to come in the second half of the year. 

Meanwhile, the Spanish statistics office said the economic slump has been deeper than feared, with lower output through 2010 and 2011. The economy slid back into double-dip recession in the third quarter of last year, three months earlier than thought.

Further evidence that the real economy of Spain is unable to carry the burden of the excess debt in the Spanish financial system.   

Credit Suisse: EU banking sector could be 'wiped out' if peripheral countries leave EU

According to a Guardian article, Credit Suisse analysis have looked at the impact of the peripheral countries leaving the EU and determined that it will 'wipe out' 58% of the book value of the banks that remain in the EU.

Given that that book capital is already a meaningless number due to suspension of mark-to-market accounting and regulatory forbearance that allows for keeping zombie borrowers alive with extend and pretend tactics, this analysis is interesting from the perspective of the magnitude of the losses.

Few large eurozone banks would be left standing and the banking sector could face a €370bn (£298bn) loss if the euro crisis results in the single currency bloc breaking apart, according to one of the first indepth analyses of what might happen if the eurozone disintegrates. 

The analysis by Credit Suisse estimates that up to 58% of the value of Europe's banks could be wiped out by the departure of the "peripheral" countries - Greece, Ireland,Italy, Portugal and Spain - from the eurozone. 

Even if the single currency remains intact some €1.3tn of credit could be sucked out of the system as banks retrench to their home markets, unwinding years of financial integration, the Credit Suisse analysis warns. This represents as much as 10% of the credit in the financial system.

Of course, this type of decline in credit would be armageddon for the real economy.

"We find that a Greek exit could be manageable ... but in a peripheral exit, few of the large listed eurozone banks would be left standing," the Credit Suisse report said. 

The banking sector could need capital injections of as much as €470bn if the three scenarios considered by the Credit Suisse analysts - a Greek exit, an exit of the periphery countries and a situation where banks retrench domestically - happen at once....

While the banks would need close to 500 billion euros to rebuild their book capital levels, this recapitalization could occur over several years by retention of 100% of pre-banker bonus earnings.

Fortunately, the EU has a modern financial system with deposit guarantees and access to central bank funding, so banks can operate for years supporting the real economy even while they rebuild their negative book capital levels.

The Credit Suisse analysts said that banks have been preparing for a potential Greek exit so the impact would be limited, so long as "it is an orderly event". 

But if there is an exit of the five countries in the periphery the the consequences for the banks in those countries would be substantial"with some of them having their tangible equity largely wiped out". Among those which would fall into this category are Intesa Sanpaolo in Italy.

Greek bank deposit run continues despite bank recapitalization as election approaches

Bloomberg reports that despite a bank recapitalization, the Greek bank deposit run has continued.

This is further confirmation that bank book capital levels and solvency are irrelevant when there is an implied or explicit sovereign bank deposit guarantee.

It also confirms that the Greek bank deposit run is a result of the EU policymakers' threats to kick Greece out of the EU and force Greece back onto the drachma.  Depositors are responding to the potential for having their savings converted into the lower valued drachma and are moving their money to avoid this devaluation risk.

Greek deposit outflows have accelerated before this weekend’s elections, two bankers familiar with the situation said, on concern the nation may move closer to abandoning the euro. 

Daily withdrawals have increased to the upper end of a 100 million-euro ($125 million) to 500 million-euro range this month, one banker said, asking not to be identified because the figures aren’t public. A second banker said the drawdown may have exceeded 700 million euros yesterday. ... 

Greek banks are under strain after individuals and companies withdrew about 72 billion euros since the nation triggered a region-wide sovereign-debt crisis in October 2009. While lenders have access to European Central Bank funding, an exit from the euro would cut them off. Depositors are seeking to preserve their cash on concern Greece may adopt a new currency that would immediately drop in value....

Economists trail mainstream media in understanding role of deposit insurance in modern banking system

In the past week, articles in both the Telegraph and the NY Times have embraced this blog's ideas on the role of deposit insurance in a modern financial system.  This puts them miles ahead of the economics profession.

In a recent NY Times column, Nobel-prize winning economist Paul Krugman lays out the economists' view on why banks need to be bailed out.

Just to be clear, Spanish banks did indeed need a bailout. Spain was clearly on the edge of a “doom loop” – a well-understood process in which concern about banks’ solvency forces the banks to sell assets, which drives down the prices of those assets, which makes people even more worried about solvency. 

Governments can stop such doom loops with an infusion of cash; in this case, however, the Spanish government’s own solvency is in question, so the cash had to come from a broader European fund. 

So there’s nothing necessarily wrong with this latest bailout (although a lot depends on the details). 

What Professor Krugman describes as a 'doom loop' is the classic formula for a run on the bank.  While the 'doom loop' is well understood, it has not existed in our financial system since the 1930s.  It was ended by FDR's administration with the creation of deposit insurance.

Deposit insurance severs the relationship between a bank's solvency and the depositor's perception of the safety of their money.  So long as depositors believe that the guarantee will be honored, they don't care whether a bank is solvent or insolvent or whether a bank has positive or negative book capital levels.

Why should they care as it is irrelevant to whether they can get their money out?  What matters is their belief in the ability of the sovereign to honor its guarantee.

The bank runs that are occurring in the EU are a direct result of increasing doubts about the sovereign's ability to honor its guarantee.  These doubts reflect

• The reduction in the sovereign's financial condition that results from borrowing to inject money into the banks (note:  this doesn't improve depositor confidence as they don't care about bank capital levels); and

• The threat by policymakers of forcing a country to convert from the euro to a less valuable currency (note:  depositors understand that forced conversion of their savings will result in their losing a sizable percentage of the value of their savings).

These increasing doubts and their related bank runs are a direct reflection of the choices that policymakers and bank regulators are making.

It would be easy to end the bank runs, simply make different choices.  Choices that take advantage of the deposit guarantee.

It is this feature of a modern banking system that allows banks to absorb all the losses on the excesses in the financial system and protect the real economy.  Banks can absorb these losses because depositors don't care about the bank's book capital level.

The choice of adopting the Swedish model with ultra transparency takes advantage of the deposit guarantee and ends the bank runs.  In addition, it removes the burden of the excess debt from the real economy.  This in turn leads to the economic growth that Professor Krugman has been calling for.

I suspect that Professor Krugman will support the choice of the Swedish model with ultra transparency.  After all, he observed

Put all of this together and you get a picture of a European policy elite always ready to spring into action to defend the banks, but otherwise completely unwilling to admit that its policies are failing the people the economy is supposed to serve....

Whatever the deep roots of this paralysis, it’s becoming increasingly clear that it will take utter catastrophe to get any real policy action that goes beyond bank bailouts. 

But don’t despair; at the rate things are going, especially in Europe, utter catastrophe may be just around the corner.

Confirmation the deposit insurance and central bank liquidity keep insolvent banks operating

David Kotok of Cumberland Advisors confirms that the combination of deposit insurance and central bank funding is sufficient to keep insolvent banks operating.

Regular readers know that this is what allows banks/Wall Street to Rescue Main Street.

Banks can recognize all the losses on the excesses in the financial system today.  This prevents burdening the real economy with the depressionary drag of carrying this excess debt and zombie borrowers.

Subsequently, banks can generate retained earnings and rebuild their book capital levels.

Notice how we have not seen TV coverage of a eurozone version of the “Northern Rock Affair.”  For those who do not remember that event, it was the run on a British bank that caused the bank to fail when depositors demanded their money.  That triggered a panic.  Disaster was averted by prompt action from the Bank of England. 

Think about it.  Greek banks have lost tens of billions of euros in deposits and yet there have been no failures.  Cyprus is bleeding deposits but no failures.  Other countries, too.  The Spanish deposit flight has been huge. 

Yet, there are no reported failures to pay euro depositors who demand their money. 

You cannot blame the depositors for seeking safety by moving their money to German, Dutch, or Finnish banks.  I would.  You would.  We advised some clients to do so.  Euros are euros regardless of which bank holds them for you.  Why take a risk with your deposit under the present circumstances, when you can avoid it. 

The euro system leadership knows that bank runs can cause their 17-country, currency-zone system to collapse.  All of banking history is supportive of this fact.  Therefore, they faced the issue when their backs were to the wall. 

The fact is the absence of banking collapses is good news.  That is correct.  Good news!  We establish that good news by what we DO NOT see on TV. We do not see banks collapsing and failing to pay depositors.  This means we may not witness the euro system collapsing and failing. 

Bank runs and deposit failures are symptoms of liquidity constraints.  Liquidity is not to be confused with solvency.  

Please re-read the highlighted text as the distinction between liquidity and solvency is very important.  So long as a bank has access to liquidity, it has time to generate the earnings needed to restore its solvency.

A prime example: Greece is certainly insolvent.  It cannot pay its debt or its governmental bills.  Nevertheless, Greece’s banks still have liquidity because of Emergency Liquidity Assistance (ELA) funding.  ELA exists the euro system agents know that they cannot permit euro system banks to fail to pay their depositors. 

Therefore, our conclusion is that liquidity issues will be addressed in the euro zone.  

The Spanish banking chapter is unfolding before our eyes.  Markets have been pricing in a fear of systemic failure on the liquidity side.  Market bears will be disappointed, because the liquidity failure is not going to happen. 

Other market agents have priced the solvency issue correctly.  

That is why the Greek stock market has been decimated.  That is why Greek bonds trade with astronomical yields.  That is why Spanish stocks are down.  That is why credit spreads are so wide.... 

Europe can fix or stopgap any illiquidity.  They have the tools with the various funding sources like ESM, with the ELA and with the hands of the European Central Bank (ECB). 

The solvency issue requires governments with strong leadership and durable commitments to change behaviors.  As we know from our own political experience in the US, this solvency/debt issue is much harder to tackle.

To date, under the Japanese model for handling a bank led solvency crisis, the EU, UK and US leaders have chosen not to tackle the solvency issue at all.  They prefer to lie about the current condition of the banks' assets and pray for a miracle to restore the banks' capital.

Central bankers and institutions around the world have the ability to offset liquidity crunches.  They know that another Lehman/AIG moment cannot be permitted.  Do they have the ability to deal with insolvency?...  

Solvency can only be dealt with if the policymakers and financial regulators adopt the Swedish model and require banks to recognize their losses and provide ultra transparency so market participants can confirm the fact.

We worry about solvency.  That is the political side of the issue, and we are not in the least sanguine about politicians in any country, including our own.  European politicians caused European government insolvency.  Can they fix it? 

European politicians cause European government insolvency by needlessly bailing out the banks in 2008/2009 and adopting the Japanese model.

What is needed is adoption of the Swedish model with ultra transparency and letting the banks fund the rebuilding of their book capital levels.

Spain's bank job accelerates towards bank run

According to a Telegraph article, almost 100 billion euros was pulled from the Spanish banking system in the first three months of the year.  Of that amount, over 65 billion euros was pulled out in March alone.

Given the credibility destroying response of the government to Bankia, there is no reason to believe that the pace of deposits leaving the Spanish banking system is not continuing to accelerate.

I know I have said this before and I will say it again, but it is still not too late to adopt the Swedish model with ultra transparency and restore confidence in the banking system.

Almost €100bn (£80.2bn) of cash was pulled out of Spain in the first three months of the year by private and corporate investors fleeing the advancing financial and political crisis. 

The Bank of Spain said €66.2bn was withdrawn in March alone – the fastest rate since records began in 1990 – taking the total to €97bn for the first quarter. 

Experts warned that the chaotic state-rescue of Bankia is likely to have speeded up the capital flight, compounding the already critical instability of the banks. 

Foreign investors have also rapidly withdrawn their support for Spanish government funding. According to figures from Barclays Capital, foreigners accounted for just 30pc of the holders of Spanish sovereign debt in March, down from 40pc at the same time last year.

Since ECB will only lend to solvent banks and all EU banks are insolvent, its time to run

According to a Bloomberg article, ECB President Mario Draghi says that the ECB will continue to lend to only solvent banks.  Since every bank in the EU is insolvent, by definition, the ECB is done lending.

Regular readers know that Mr. Draghi's statement is in direct contradiction to the rules for central bankers laid out by Walter Bagehot in the 1870s and discussed on this blog.

Rule number one for central bankers is that in times of crisis they are suppose to lend freely against good collateral at high interest rates.  This rule says absolutely nothing about whether the bank that is borrowing the money is solvent or not.

In fact, by writing the rule the way he does, Mr. Bagehot shows that he understands that bank solvency can change over time as it is defined as the current value of the bank's assets minus the book value of its liabilities.

In times of financial panic, assets tend to be valued at substantially less than they would be in more normal times.  As a result, a bank that is solvent in normal markets could be insolvent in a financial panic.

U.C. Berkeley Professor J. Bradford DeLong confirmed my reading of Mr. Bagehot in his article This Time, It Is Not Different.

As for the statement that all EU banks are insolvent, there are a number of different pieces of information that confirm this observation.

First, one need look no further than the latest EU stress test that showed that both the Netherlands bank Dexia and the Spanish bank Bankia passed.  Both has subsequently been nationalized.  In short, everyone knows that passing the stress tests does not equate to a bank being solvent.

Second, we have policymakers taking actions to bailout the banks.  For example, the Greek bailout was designed so that the money from the EU would flow directly to the banks.  A clear sign that the policymakers don't think the banks are solvent.

Third, we know that under regulatory forbearance the banks are hiding losses on and off their balance sheets (please note, if a bank were not hiding losses, it would provide ultra transparency to let market participants confirm this point and show that it can stand on its own two feet).  What this means is that the banks themselves cannot tell who is solvent and who is not.  As a result, the interbank lending market has frozen.

Fourth, we know that banks are still interconnected.  Are German banks really solvent if the insolvent Greek, Spanish and Italian banks trigger insolvency in the French banks too?

Given that Mr. Draghi says the ECB is only going to support solvent banks, then it is pretty clear what the prudent course of action is for EU depositors.  Run to their bank and withdraw their money before the system collapses.

Perhaps the ECB and Mr. Draghi would like to rethink their position...

European Central Bank President Mario Draghi said policy makers will keep focusing their crisis support on solvent euro area banks as he reiterated it’s not the ECB’s job to fix the cause of the region’s turmoil. 

“The ECB will continue lending to solvent banks and will keep the liquidity lines active and alive with solvent banks,” Draghi told a European Union Parliament committee in Brussels today....

 So much for lending to any bank in the EU.

When pressed on whether the ECB can step up action to tame financial turmoil and help cap widening bond spreads, Draghi said that “it’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front.”

Draghi signaled the ECB is in no rush to introduce a third three-year loan program as the turmoil hasn’t arrived at “the same levels reached in November 2011,” when such aid was first mooted. While the ECB’s lending can help improve bank liquidity, it cannot address risk aversion and capital shortages in the banking sector, he said. 

Apart from funding “there are two other issues that are now hampering credit flow, one is risk aversion” and “the second is lack of capital,” Draghi said. “We cannot do much about the two other reasons about the slowing in credit.”

Keep in mind, Mr. Bagehot says that central bankers should never, ever look at a bank's capital position.

Central banks are senior secured lenders who haircut any collateral they take prior to extending a loan.  As a result, the only issue the central bank should focus on is correctly valuing the collateral.

This is a point Paul Volcker made several years ago when he said that central banks should evaluate the collateral pass the point of no return.  Central banks should assume that the bank will default.

Draghi hinted that he is in favor of using the permanent bailout fund, the European Stability Mechanism, to be used to inject capital into banks. 

“People are actually working on finding ways that the ESM could be used to recapitalize banks,” he said. “ The issue is not so much the use of ESM money to recapitalize banks but whether this could be done directly without having to go to governments.”...

A far more effective way to use the ESM is as a backstop to deposit guarantees.

He said one of the lessons drawn from the Bankia (BKIA) group’s need for a 19 billion euros capital injection is that “further centralization of banking supervision is needed,” as national governments and supervisors tend “to first underestimate the importance of the problem, then come out with a first assessment, then a second, then a third, then a fourth” and “all countries have done the same thing.” 

This is “the worst possible way of doing things” as even though in the end they do the “right thing, but at the highest possible cost and price,” he said. He also urged governments to “err on the high side” when recapitalizing banks.

Actually, the lesson is that banks should be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this information, the market will assess the banks and determine the extent of the problems.

The ability to use the market's assessment of the problem saves the government from destroying its credibility when it consistently underestimates the true extent of the problem.

Finally, in a modern banking system with deposit guarantees and access to central bank funding, there is no reason for a government to step in and recapitalize a bank.  The banks are perfectly capable of rebuilding their book capital levels through retention of future earnings.

It is only when a central bank stops lending based on a bank's current solvency status that a modern banking system collapses.

EU still searching for way to stop bank run contagion caused by redenomination risk

The EU is scrambling to find a way to stop the risk of bank runs across the peripheral countries if Greece is forced back onto the drachma.

Regular readers know that your humble blogger has suggested an easy solution:  adoption of the Swedish model with ultra transparency.

Under this solution, the banks will absorb the losses on the debt in excess of the borrower's capacity to repay.  If this were done, then Greece would not be forced onto the drachma and the risk of bank run contagion resulting from forced redenomination would go away.

As reported by Reuters, the EU is pursuing alternatives endorsed by bankers that don't require the banks to recognize the losses hidden on and off their balance sheets.

As the euro zone ponders a possible Greek exit, policymakers have not yet built a shield robust enough to prevent a bank run in one country sending others in the bloc deeper into crisis.... 

But a wave of withdrawals by depositors - either for fear that their government is too weak to stand behind its banks or that their country will exit the euro and switch their savings into a vastly devalued national currency - would represent a whole different scale of crisis. 

Such pressure on Ireland's banking system prompted a national bailout by the International Monetary Fund and European Union. 

Now investors are worried about the contagion effect a Greek exit from the euro zone could have on savers in other countries. 

"Preventing bank runs in Italy, Spain and Portugal should be the top priority," said Berenberg Bank economist Holger Schmieding. "Policymakers need to make sure that the potential Greek precedent of a forced conversion of domestic euro deposits into a weak new currency would not spark a run on banks ... elsewhere."

Bank runs in these other countries are already taking place.  

The ECB is pressing the euro zone to set up a fund that would prevent this dangerous ripple effect, a message reinforced by ECB policymaker Joerg Asmussen last week. 

"The recapitalization of a troubled bank by its government may lead to a deterioration of the government's fiscal position," Asmussen said. "The deteriorating fiscal position in turn further weakens banks' balance sheets, through their holdings of sovereign bonds. 

"This feedback loop has to be stopped ... A European bank resolution authority and a European deposit insurance scheme are two elements that could be used to address the nexus between sovereigns and banks."

Adopting the Swedish model with ultra transparency stops the feedback loop.

As regular readers know, in a modern financial system with deposit guarantees and access to central bank funding, banks can operate and support the real economy for years with negative book capital levels.

In fact, a modern financial system is designed so that bank book capital is suppose to act as a safety valve between the excesses in the financial system and the real economy.  Banks do this by absorbing the losses on the excess debt in the financial system today and rebuilding their book capital levels through retention of future earnings.

There is no reason in a modern banking system for governments to recapitalize the banks.  As the IIF pointed out, the banks in Spain should generate enough earnings over the next 4 years to absorb all the losses that the IIF forecast.

Finally, I agree with the call for a European deposit insurance scheme.  It is part of my blueprint for saving the financial system.

Any pan-euro zone deposit guarantee scheme would need to be large in order to stem ebbing confidence. 

The typical national guarantee in Europe now covers the first 100,000 euros on deposit, something that would do little to reassure corporate investors with millions. 

It was the decision by companies in Ireland to withdraw deposits that accelerated its banking crisis....

Under my blueprint, the combination of the European Financial Stability Fund and the European Stability Mechanism is more than adequate as the only banks that need to be restructured or closed are those banks that do not have a viable franchise.  Where viable reflects the capacity to rebuild their book capital levels through retained earnings.

In the absence of a resolution fund or insurance scheme to deal with a bank collapsing, many investors expect the ECB would act to head off a bank run or a similar systemic threat.... 

In the case of Greece, the belief is that the ECB would act again to contain a bank run, said Clemens Fuest, a professor at Oxford University and a member of the academic advisory board of the German Federal Ministry of Finance. 

"The expectation seems to be that the ECB will prevent it by providing whatever liquidity is needed," he said, adding that this could either be from the ECB directly or as emergency funding from the Bank of Greece with the ECB's backing....

It is comments like this that reflect how little academics understand about a modern banking system and deposit guarantees.

In a modern banking system with deposit guarantees, depositors do not care about the current level of bank book capital or whether the bank is currently solvent or not.  All depositors care about is that the guarantee will be honored.

There are two reasons the guarantee might not be honored.  First, the sovereign does not have the financial capability.  Second, deposits are subjected to forcibly exchanged from a stronger currency into a weaker currency.

In the presence of either of these reasons, there are bank runs.

What the ECB can and does do is provide liquidity to the banks so that depositors can withdraw their funds.  

The banking environment has steadily deteriorated, according to statistics from the Bank for International Settlements, which chart the flight of capital from the euro zone's weakest members. 

Figures from December last year show a sharp decline in deposits from abroad held in banks in Greece from $160 billion in late 2009 to less than $80 billion. 

Ireland's bank deposits from abroad fell from $905 billion to $471 billion over that time and a similarly sharp fall was seen in Portugal. 

Households and companies have almost 11 trillion euros on deposit with banks in the euro zone, with over 3 trillion in Germany alone, according to ECB statistics....

Further confirming the on-going bank run from the EU periphery countries to the core countries.

Draghi is pressing governments rather than the ECB to take the decisive action and delivered a stark message last Thursday, saying: "We have reached a point in which the process of European integration needs a courageous leap of political imagination in order to survive."

The courageous leap of political imagination is to adopt the Swedish model with ultra transparency.