Over the past five years, there has been a profound shift in the transatlantic bank regulatory regime. Following the 2008 crash, insolvent banks were recapitalized by governments, and bondholders and uninsured depositors were fully protected from credit losses. Indeed, a very large number of major banks in the US and Europe were rescued and recapitalized by governments during this period, at no loss to their creditors or depositors.
Subsequent to these unpopular bailouts, financial policy has shifted from protecting bank creditors to exposing them to loss in the event of a capital shortfall. This is variously called “private sector involvement”, “stakeholder bail-ins”, and “market discipline”.
The rationale for this shift is that taxpayer funds should not be spent to protect bondholders and depositors, that creditors should take losses prior to governments, and that creditors should “do their homework” before investing in a bank’s liabilities. This new policy is seen as fair and prudent, and it is expected to lead to better policy outcomes in future banking crises.
Going forward, bank creditors will be expected to discriminate between strong and weak banks on the basis of their external financial reporting. This concept extends even to uninsured retail depositors such as those that were wiped out in the Cyprus banking crisis.
The policy architecture of market discipline rests upon four fallacious assumptions: (1) bank creditors are skilled in bank credit analysis; (2) bank financial reporting is sufficiently transparent to enable creditors to discriminate between solvent and insolvent banks; (3) the default of a large bank upon its liabilities will not create contagion and a general bank run; and (4) a flight to quality would not impact the real economy.
Each of these assumptions is erroneous: few bank creditors or depositors know much about bank credit analysis; bank financial reporting bears little relationship to bank solvency; a major bank default will likely result in runs on other banks perceived as weak or illiquid; and banking crises have macroeconomic ramifications–deflation and depression.
Creditors Know Little About Bank Credit Analysis
The foundation of bank credit analysis consists in the entering the reported financial data of a banking peer group (e.g., Irish banks) into a multi year database on a comparable basis, and then calculating ratios to enable comparison across banks and across time periods. This, by itself, is a monumental and labor-intensive task, and is generally performed by data vendors on a subscription basis.
Retail depositors have no access to these databases, and would not know how to use them if they did. There are credit rating agencies who perform their own bank credit analysis and offer credit opinions, but are the rating agencies supposed to be the foundation upon which rests future financial and macroeconomic stability? Do the authorities really intend to outsource financial and economic stability to the credit rating agencies? If not, then bank creditors and uninsured depositors will face a very steep learning curve indeed, and are likely to make serious mistakes.
Bank Accounting And Bank Solvency Are Often Unrelated
Banks typically report good profits and strong capital ratios prior to rescue or failure. An analysis of the financial reporting of failed or rescued banks will reveal that almost all of them were reportedly profitable and solvent before they failed. This is for two reasons: (1) failing banks generally accrue interest on bad loans, recognizing this fictitious interest as income; and (2) such banks generally hide their bad loans and do not create remotely adequate loss provisions prior to their recaps (see: Bankia, Banca MPS, WestLB, Depfa, RBS, Anglo-Irish, BofA, Citi, etc.).
This is why, when a bank fails and has to be resolved, the cost of resolution will typically reveal an insolvency much deeper than ever suggested in its public financial statements. Often the insolvency is a multiple of the bank’s reported capital; the difference between 6% and 8% capital under such circumstances is irrelevant. Speaking from my personal experience, the single best source of information about bank solvency is market rumor–because that’s generally all there is besides the official lies.
Uncontained Bank Failures Create Contagion
When a major bank is allowed to default upon its liabilities, the market reacts by withdrawing credit from banks with a similar profile. This phenomenon occurred most recently in 2008, when the bankruptcy of Lehman Brothers Holdings lead to a withdrawal of credit from the other Wall Street banks, which necessitated the TARP bailout and the extension of extraordinary credit from the Fed. In a banking crisis, the mutual withdrawal of credit tends to be indiscriminate and fear-driven. The idea that, in the midst of a financial crisis, participants will choose to make fine distinctions between banks is not borne out by historical experience. In a flight to quality, many dominoes will totter. If one weak bank defaults, the market will attack the rest of the herd.
Banking Crises Have Macroeconomic Ramifications
Banking crises affect the macroeconomy in two crucial ways: credit contraction and monetary contraction. Following the shocks of the Lehman and Greek crises, credit contracted in both Europe and the US in what is characterized as a “Minsky Moment”. Prior to the shocks, credit growth was strong; after the shocks credit growth turned negative (credit growth did not merely decline; the credit aggregates contracted). Borrowers who were considered bankable before the shock instantly became unbankable afterwards. The desire of creditors to call in their loans during a crisis has immediate implications for confidence and growth because forced asset liquidations are deflationary. Economies cannot grow when credit is contracting. The “healing process” is in fact a prolonged disease.
Secondly, banking crises interfere with the efforts of the authorities to maintain adequate money growth as banks seek to shrink their balance sheets. Unless heroic measures are taken by the authorities to force money into the system, the money supply will contract along with the banking system, thus unleashing powerful deflationary forces. We saw this briefly in the US in 2009, and we are seeing such a deflationary spiral today in southern Europe, where money growth, inflation and economic growth are all near or below zero–and this is without any major bank failures so far.
The Coming European Depression
We are now awaiting the results of the ECB’s asset quality review of the largest banks in the Eurozone which, if it is honest, will reveal large unrealized loan losses at many banks, and not just in the Club Med countries. In some cases, it is likely that these banks will be unable to raise sufficient additional equity to restore their solvency, thus creating the preconditions for a bail-in, whereby creditors would be required to transform their debt claims into equity. Should the bail-in policy result in major debt defaults, the consequences will be highly contractionary no matter what the ECB does.
The European authorities have created a lethal policy brew, imposing deflationary monetary policies while withdrawing the financial safety net, repeating the American experiment of 1930-33. As Irving Fisher wrote in 1933:
“Unless some counteracting cause comes along to prevent the fall in the price level, a depression tends to continue, going deeper, in a vicious spiral, for many years. There is no tendency of the boat to stop tipping until it has capsized. Only after almost universal bankruptcy will the indebtedness cease to grow. This is the so-called natural way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.” (The Debt-Deflation Theory Of Great Depressions)
There are two ways that Europe’s banking problems can be resolved: by default or by inflation. Inflation is regarded as sinful and “the easy way out”. Why take the easy way out when depression is so much more painful? Europe has chosen the path of default, deflation and depression, and in the process will relearn the lessons that Professor Fisher identified over eighty years ago.