Eurozone banks face huge losses relative to capital
Banks provide transactions services to their depositors. As the essence of transactions services is that they are conducted in “money” (i.e., an asset with 100% nominal value certainty, at least in principle), banks’ assets must also be characterized by nominal value certainty and – in that sense – be very safe. Safe assets generally offer low returns. In order to overcome the low returns and provide their shareholders with respectable returns on equity, banks are usually both highly geared (i.e., with high ratios of assets to equity and other kinds of capital) and fractionally reserved (i.e., with cash – which they must keep in reserve in order to hand back over the counter to depositors – a very low fraction of total assets).
In normal circumstances government bonds and inter-bank deposits are two of banks’ safest assets. Banks’ asset acquisition patterns in the initial successful period for the euro (i.e., from the introduction of the euro on a scriptural basis in 1999 to the closing of the inter-bank market in August 2007) reflected the almost universal belief in the safety of these two asset types. Government bonds issued by countries running very large current account payments deficits (such as Greece and Spain) were taken to be almost as credit-worthy as government bonds issued by Germany and the Netherlands. Similarly, confidence in the likely repayment of deposits left with banks headquartered in high-deficit Mediterranean countries enabled such banks to borrow heavily from other banks. With the onset of the severe phase of the Eurozone crisis since early 2010, the standard assumption about the safety of government bonds and inter-bank deposits has been invalidated. The press has begun to report open discussion among Eurozone member states of changes in the membership of the Eurozone. The contractual basis of the single currency is therefore in question. Two dangers may be highlighted, although this is just a small sample of the potential problems.
Change in currency denomination of government bonds
Everyone now accepts that Greece (and then almost certainly Cyprus, but perhaps with Italy, Portugal and Spain not far behind) could leave the Eurozone, and that the new Greek national currency (“the new drachma”) would lose value immediately relative to the euro. (The devaluation might be 30% or more.) Although Greece would soon see domestic inflation and a rise in the price level (and hence in national income), the ratio of public debt to GDP would soar if Greece continued to express its government debt in terms of euro. (In fact, for a devaluation of a third, the ratio of debt to GDP would rise 50%, i.e., from 160% to 240%, at one fell swoop.) Almost certainly the Greek government would redenominate its debt in terms of new drachma at the exchange rate prevailing just before the devaluation. (So – if the new drachma began life at par with the euro – the existing debt would be redenominated with the same figures, but in new drachma, not euro.) The result would be to inflict massive losses on all foreign holders of Greek government bonds in terms of the euro, because of the devaluation. (The precise relationship between such losses and the 50% “haircut” already proposed for private creditors of the Greek state is unclear to me and, I suspect, many others.)
Change in currency denomination of inter-bank lines
The departure of Greece from the Eurozone would be accompanied by the redenomination of both the “Greek” assets and liabilities of “Greek” banks. However, the notion of “Greek”-ness is difficult. Presumably, a deposit held by a Greek citizen who is resident in Greece in a Greek-owned bank located in Greece can – indisputably – be redenominated in new drachma. But – on any of the four implied dimensions (citizenship of depositor; residence of depositor; ownership of the bank taking the deposits; location of the bank taking the deposits) – the notion of “Greek”-ness could be diluted. The deposit might be a German citizen resident in Greece etc.; the deposit might be held by a Greek citizen resident in Germany, and on and on it will assuredly, legally go. Such uncertainty about the correct currency denomination after Greece’s departure from the Eurozone is most critical with inter-bank deposits, since – as is well-known – the banks in the PIIGS group (Portugal, Ireland, Italy, Greece and Spain) funded their asset growth in the 1999 – 2007 period heavily from foreign banks. The obvious procedure for Greek banks with borrowings in euro from other Greek banks would be for these borrowings to be redenominated in new drachma. But what about borrowings from, say, German or Dutch banks? If the borrowings were redenominated in new drachma, the German and Dutch banks would take a capital hit reflecting the new drachma’s devaluation. On the other hand, if the borrowings remained denominated in euros, a high probability is that Greek banks could not recover the loans in full in euro terms from their Greek debtors and – if the Greek banks then suffered losses which wiped out their capital – they could not repay the inter-bank borrowings anyway.
In short, banks in the Eurozone are likely to experience heavy losses over the next few years on assets which were supposed to be extremely safe as recently as early 2007. Further, the distribution of the losses between banks in different countries is open to negotiation and, at this stage, it is also a matter of conjecture. Because of the ambitious gearing which is an inherent characteristic of banking, the losses on sovereign debt and inter-bank exposures will eliminate a high proportion of Eurozone banks’ capital. Again, the distribution of losses between the banking systems of different countries is already – and will remain for a number of years – the plaything of politicised bargaining (and, for example, lawyers’ interpretations of precedents).
The principal players in the Eurozone’s management have now realized the extremely dysfunctional character of the multi-government monetary union envisaged in the 1992 Maastricht Treaty and put in place over the following decade. But they can also see the appalling tensions – because of the somewhat arbitrary redistributions that would occur due to contract redenomination – if the Eurozone were to dissolve or even to suffer a significant change in membership. They will therefore do whatever they can to prevent countries leaving the Eurozone. And clear misgivings have now arisen about the attempt, at the famous/notorious summit on 27th October, to impose a 50% “haircut” of loss on private holders of Greek debt. All investors now realize that the debts of any Eurozone government are now not 100% safe, even when denominated in euros.
Nevertheless, banks must make provisions on the losses that now seem inevitable on sovereign bonds and inter-bank exposures. The severity of the losses will depend not only on the contract redenominations, but also on underlying loan losses that would occur even if the the Eurozone were intact. The severity of such underlying loan losses will depend – in turn – on the overall macroeconomic environment. If the Eurozone dissolves while prices (including the prices of the real estate which usually serves as banks’ loan collateral) are falling, more banking system capital will be destroyed than if the Eurozone breaks up in an inflationary context.
What does the analysis imply for policy towards the Eurozone’s break-up or, at any rate, its reformation? I have two main suggestions, both set out below.
Policy suggestion I: the need for a burst of rapid money growth
The exact scale of the prospective banking system losses is uncertain. Of course, there is a risk that banks will attempt to downsize their assets and balance-sheet size in line with the erosion of their capital bases. A downward “debt deflation” spiral of the kind conceptualised by Irving Fisher in 1933 might then eventuate, with a crash in the quantity of money, and disastrous consequences for output and employment.
The simplest method of averting a debt deflation is for “the monetary authorities” (i.e., the central bank, but the central bank working with “the government”, which in the unfortunate case of the Eurozone means 17 governments) to engineer a sudden, big increase in the quantity of money. As I and others have argued on several occasions since the crisis began, an appropriate mechanism is for the authorities to buy back large quantities of government bonds with balances created by borrowing from the banking system (i.e., by the authorities – either the government or the central bank – exploiting their own credit-worthiness when private sector credit-worthiness has been shot to pieces). When the authorities credit the sellers’ bank deposits with the purchase money for the bonds, bank deposits (and hence money) increase. Assuming the operation is on a large enough scale and compressed into a short period of time, the effect – fairly quickly – is to ease balance-sheet strains throughout the economy, to spur gains in asset prices and so to motivate a recovery in spending. The Bank of England’s QE operations in 2009 and at present exemplify the implementation of a programme of this kind. (I have written a great deal about QE and QE-type operations since 2008, and don’t want to repeat myself. In October and November the ECB bought noticeable quantities of government bonds, choosing the bonds of governments that were in difficulties funding themselves from market sources. The rationale for these purchases seemed to be nothing more than that the ECB wanted to make a display of “doing something”. The media made a fuss about the purchases. But the ECB’s operations were not targeted to deliver a large increase in broad money and had only a limited effect on the monetary base. Indeed, in October M3 actually fell.)
In my view, the governments of the Eurozone member states should agree among themselves that each of them will borrow from the commercial banking systems of their own countries, say, 5% of GDP in 2012, with the deliberate object of creating money. The ECB does not need to be involved in these operations as such, although it should of course be informed. The effect would be to shorten the average maturity of government debts which – in many ways – would be unfortunate. But, somehow or other, a burst of money growth is needed to prevent a ruinous debt deflation which could wipe out hundreds of billions of euros of bank capital, and would be accompanied by precipitous declines in demand and employment. If the Eurozone top brass (Merkel, Sarkozy, the Troika, etc.) are afraid of inflation, fair enough, but high inflation is not an imminent threat. They must also understand that a severe debt deflation would stigmatize the single currency idea in Europe for at least a generation and perhaps forever.
Policy suggestion II: bank recapitalisation should be gradual
I have argued in several places that Big Bang bank recapitalization (i.e., comprehensive recapitalizations compressed into a very short period of time without regard to shareholders’ property rights) can be highly deflationary. The explanation is obvious enough if officialdom demands an increase in capital/asset ratios on the grounds that it wants banks to be safer. With capital given, an increase in K/A ratios must mean shrinkage of banks’ assets and hence of the deposits which constitute most of the quantity of money. But, even if officialdom does not press for an increase in K/A ratios and merely asks the banks to have more capital, the initial effect of the recapitalisation is to reduce the quantity of money. (Depositors’ claims on the banks – which were money – become claims on the banks in the form of equity and bonds, which are not money.)
Current developments in the Eurozone could lead to the wiping-out of many hundred billions of euros of bank capital. It is vital that banks continue to operate – in terms of handling their debtors – as if the capital were still there. They must not pull in loans, sell off securities and destroy money. They must be given time to rebuild their capital and to reorganize their balance sheets. In that interval banks’ operating profitability is likely to be handsome. As long as regulation is benign and friendly (which, conspicuously, it has not been since 2008), capital will flow into the Eurozone banking system from banking systems across the world, and a major calamity should be prevented.
No one knows the changes in the composition and structure of the Eurozone that may emerge in the next few years. The banks could not have foreseen – and could not have been expected to foresee – the immense damage that these changes would inflict on their profits and capital. Strict adherence to the letter of the Basle capital rules could initiate exactly the debt-deflationary downward spiral that must be avoided. My suggestion is that
a.) governments across the Eurozone endorse low-cost finance from the state (perhaps by the purchase of preference shares issued by commercial banks to the government or central bank, with a coupon of – say – 5% or 6%) to banking systems to compensate on banks’ balance sheets for the lost capital; b.) this finance is to remain in place for the long period that is likely to be necessary for bank balance-sheet rehabilitation (which may well be longer than a decade); c.) while the low-cost state finance continues, banks pay no dividends to equity shareholders; d.) because of the long period of convalescence envisaged for the banks, they need merely to make provisions for expected bad debts and not to write off the full amounts they might eventually lose (and accountancy standards must be interpreted flexibly for some years); e.) the effect of (c.) will be that all operating profits are retained for the rebuilding of capital: &, f.) once the rebuilding of capital has been on a sufficient scale, the banks repay the low-cost finance from the state and operate in a normal fashion (i.e., with a high proportion of profits being distributed to equity shareholders).
Send them home in an ambulance
The 17 Eurozone government need to reach a concordat on the size and terms of the finance extended to their banks, since major competition issues could arise; they also – almost certainly – need some sort of exemption from the existing EU competition directives. The (relatively) cheap finance would be intended to give banks a period of grace to rebuild capital; it would not be meant to facilitate unfair competition with banks from other EU countries. My guess is that a “normally operating” banking system (or systems) will return only in the mid or late 2020s.
In effect, banks are put into hospital for an extended period of time so that the wounds can heal. Losses arising from a Eurozone break-up/reformation are not, in any meaningful sense, the banks’ fault. The blame falls on the European Union’s political and bureaucratic elites for pressing ahead with the single currency project in the 1990s. For them the project was seen as part of the European “construction”, but in truth they had not attended to the structure’s foundations and plumbing. I have not said anything here about the extent of the Eurozone break-up/reformation (in terms of the numbers and names of countries leaving) that might take place. Roughly speaking, the larger the number of countries that leave the Eurozone and the heavier the devaluations of the weak members, the longer is the likely period that the banks must remain in hospital.
Tim Congdon is the founder of International Monetary Research Ltd.