The source of the long-term, low-cost loan(s)
Bank hospitalization may sound unappealing, but – as long as the quantity of money is growing at a moderate rate – it ought to be consistent with a satisfactory macroeconomic environment. Most businesses in the Eurozone economy (or in the economy of the Eurozone and its former member states) ought to carry on without too much trouble. However, where should the long-term, low-cost loan come from? I’ve argued that governments should “endorse” such loans, without spelling out the source of the finance.
An obvious possibility is that governments themselves could borrow (either from capital markets or from banking systems) and extend the loan. However, this would amount to semi-nationalization, and would no doubt excite yet more lurid and inappropriate press comment of the kind that has been far too common in the last few years.
I am not saying a loan from a government source would fail. In fact, a precedent for this approach to bank rehabilitation was set in the USA in the 1930s. The Federal government created the Reconstruction Finance Corporation on 22nd January, 1932, with an initial capital of $500m. subscribed by the government. [$500m. was a bit less than 1% of the USA’s GDP at that time. An organization of similar size today, relative to the whole economy, would have a capital of almost $150b.] It could borrow three times its capital, a figure later increased to about six times its capital. The RFC helped the banks, by purchasing preferred stock issued by the banks at a dividend yield on the nominal capital of 6% a year. In fact, the RFC arrangements in the 1930s are a good illustration of how long-term, relatively low-cost finance from the state can extricate a banking system from apparent systemic collapse. But one reason it worked was that the growth of the quantity of money in the USA in the three years, 1933 – 36, was extremely fast.
An alternative would be for central banks to extend the loan facilities. Since central banks can create new high-powered money “out of thin air”, this option would be painless in the first instance. It would also have the advantage that central bankers are more likely to see a community of interest with commercial bankers than government bureaucrats, and to understand the technical aspects of bank accountancy, balance sheet management and so on. It is taken for granted here that – in the remaining Eurozone and in the economies that once belonged to the Eurozone, but have restored their national currencies – the long-term, low-cost finance is provided to commercial banks by Eurosystem central banks.
The mechanics of bogus recapitalization
Of course the central bank might not be able to recover in full the loans to the commercial banks, despite the long period envisaged for repayment and the substantial operating profits that ought to build up in the banking system. In the extreme the central bank might have losses on its loans in excess of its own capital. (Indeed, there is little doubt that at present the Eurosystem of central banks – i.e., the central banks of the Eurozone’s member states – would have huge losses, relative to its capital, if it were required to write down its sovereign debt holdings to the market price.) However, the balance-sheet proprieties can always be maintained within the public sector by an accountancy trick that is well-known to finance ministers and bankers in developing countries that have been through severe banking crises, hyperinflations and other pathologies of macroeconomic disorder.
Consider a central bank owned by the government. On the liabilities side of the balance sheet are to be found deposits, held by the commercial banks as “cash reserves” (i.e., reserves in the central bank’s case, and equity, which belongs to the government, and in the initial situation government securities constitute all of its assets. Let us start off with 50 billion units (they could be euros, drachma or whatever, it doesn’t matter) of both deposits and equity as liabilities, and 100b. units of government securities as assets. In the first transaction under consideration here the central bank extends a new loan which is, for the sake of argument, 100b. units. 100b. units are added to banks’ deposits with the central bank and 100b. to a new loan extended to the banks.
After a few unhappy years the commercial banks come back to the central bank and say, with the best will in the world, they can repay only 40b. of of the 100b. loan. So 60b. of the loan has been lost, which exceeds the central bank’s capital. The central bank is “bust”, with the government’s equity stake wiped out. This looks pretty grim, but all is not lost. Remember that the central bank’s notes are legal tender by law and must be accepted in payment, regardless of the state of the central bank’s balance sheet. The central bank extends a new loan to the government of 50b units, with 50b. extra on the assets side of the balance sheet (which is of course the new loan) and 50b. added to the government’s deposits on the other side of the balance sheet.
In the final stage the government decides to restore the balance-sheet proprieties by converting its deposits into capital. This is simply a matter of relabeling, which costs nothing. In the final situation the central bank has been fully recapitalized and life can carry on pretty much as before! Superficially, the banking system has lost the bulk of a large loan extended to it by the state and no one has suffered. What magic these accountancy tricks can perform!
Bogus recapitalization hides banking failure to use resources efficiently
Recapitalization of banking systems by this sort of trick may give the appearance that all is well. That is not so.
All sorts of games can be played with figures inside the public sector, in order to comply with “balance-sheet proprieties”, and yet have the effect of hiding appalling blunders in the allocation of resources. The key point is that – were a private sector shareholder to permit relabeling of this kind – he or she would undoubtedly have “lost money”, certainly in the sense of not receiving dividends from capital for many years. Given that the expected return on equity investments in the long run in most capitalist economies is 6% - 7% real (and so about 10% nominal, assuming some inflation), the opportunity cost of many years of dividend starvation hurts shareholders and reflects mistakes made by banks’ managements in the direction of credit. Inside the state sector the cancellation of debts hurts no one in particular, but is the representation in accounting terms of similar mistakes in the direction of credit and the resulting allocation of resources. Society as a whole is the loser.
Much of the Chinese banking system is state-owned. Analysts have worried for a few decades that the state-owned banks hide immense losses, due in particular to foolish loans on real estate. Many Chinese cities have estates covering several square miles of unoccupied tower blocks, for both residential and commercial use, which have clearly been bad investments. When the construction of these building has been financed by bank loans to private developers and the private developers cannot repay the loans, the banks must have big losses. But – because the banks are state-owned – the losses can be “written off” by the sort of bogus recapitalization described here.
The importance of this discussion to the Eurozone crisis is that the ECB, and indeed the national central banks in countries with a restored national currency, may well face large losses on the assets acquired in the recent and on-going crisis period. Among the unsatisfactory assets might be the long-term, low-cost loan or loans to the commercial banks I have discussed. If so, a merit of the “magical” bank-recapitalization approach is that the losses are spread around the entire community (just as taxes are) rather than concentrated on, say, the depositors of one bank or a handful of banks. An ECB recapitalization organized in the way I have outlined does indeed seem inevitable at some point in the next few years, probably after the crisis has been resolved.
It goes without saying that – if banks have received a low-cost, long-term finance from the central bank and cannot pay it – the state is fully entitled to appropriate part or all of the equity of the banks in question. However, the hope must be that, given an appropriately long period for repayment, the build-up of retentions from operating profits allows the banks to remain in private ownership, with all the resulting benefits in terms of management motivation, credit direction and resource allocation.
Tim Congdon is the founder of International Monetary Research Ltd.