Does An Irish Solution loom for European Banks (one way or the other) ?

brokenbankThis is a version of my column in the Irish Examiner of 25 Jan 2014 .Europe’s banks are broken. Very broken. We have always suspected that, but recent evidence in indications suggest that nearly six after the crisis first began to manifest itself seriously they are still grossly impaired. The drive towards meaningful banking union has stalled again amidst squabbling about whether or not there should be and if so how much of a common pot for resolution.  German banking giant Deutsche unveiled a billion euro loss just this week, underscoring how fragile both the banking system and the economy remain, even at the core. Without a working banking system the economy cannot prosper.

Recall what it is that banks do – despite the mystique and the bluster, its actually pretty simple. Some people have money and others need it. Banks act as a middleman to facilitate those that want it to get it from those that have it, in return for them taking a cut of the interest charged. This can be across space (savings flow from region to region) and/or time (mortgages and longer term loans) . Lending money out is risky. That is why banks charge an interest rate on loans that is greater than that which they pay on deposits – apart from needing to make a profit and cover costs, they need to put some money aside for the inevitable defaults and bad loans.  These retained profits, plus some other ‘safe’ assets, are the banks reserves, or its capital

There is a persistent fallacy that banks lend out reserves. They don’t. People such as Frances Coppola have been banging on about this fallacy for some time now (see here and here)  Its more complicated than that and revolves around the fact that banks can create credit (money) by issuing loans. However,  banks  do need, under prudential regulation, to hold a certain amount of capital, a proportion of the assets they have (loans made).  If banks have more capital they are in a position to expand. The problem for  European banks is that they are stymied by the fact that they have written down bad loans to an extent sufficient to impair their capital base but by no means enough to clean their balance sheet of the these bad loans. Caught in a double bind, they are unable to efficiently do their job as intermediaries and as credit creators.

As part of the ongoing efforts to get to the root of the problem the ECB have initiated an asset quality review. This is in effect yet another stress test. Previous not-terribly-stressful tests have been greeted with derision as they in effect claimed that all was well when it was manifestly not. Thus this stress test, to be credible, needs to fail some banks – any banks.  It is reminiscent of Admiral Byng, who was shot not for failing at his task of taking Minorca, more or less impregnable and a rock on which others had foundered, but ‘pour encourage les autres’.  European banks all stand in danger of being the financial Admiral Byng of 2014. One or more large banks needs to fail to show the virility of the tests.

Recent research has looked at what holes might be lurking in the capital. As has been the case throughout this crisis while high level public data cannot give a precise amount it has been remarkable how using such data the gross magnitude and nature of the money sink de jure has been accurately estimated. Looking at the 109 largest banks with €22 tr in assets a hole of between 5b and 66b is found even assuming no further deterioration of any assets – an unstressed situation.  The biggest holes are in the core – French and German banks and the smallest in the periphery. Ireland, if things don’t get any worse, does not need any more capital in its banks.

But what if things do go south? They stress the banks rerunning a severe financial crisis, and further suggest that any residual bad loans are written off. Writing off bad loans of capital weak banks is the only way to kill zombie banks who crowd out and hinder the banking system.  In this stress situation the banks are woeful. Assuming reasonable levels of reserves to be held, European banks may need between 500b and 750b. Again the worst holes are in the core banks  especially French German and Belgian banks. Top of the list are the giant french banks – Credit Agricole, BNP and SocGen, and Deutsche Bank. Bank of Ireland and AIB are not immune, possibly requiring 6-13b euro more. But sure were good for that, havent we turned the corner and exited the bailout to a land of green shoots…

So what to do? Senior bondholders are sacrosanct and while depositors of unimportant nations such as Cyrus (whose banks are still bunched beyond reasonable hope of redemption) might be bailed-in that wont happen to real depositors, those of the core. So banks will limp along. But there is a potential solution – promissory notes. The notes were created to shore up the capital base of Anglo Irish Bank, and allowed it to access liquidity from the Central Bank of Ireland. Which it did. Ok, Anglo was a hopeless case but the principle is good. The problem with the notes was not per se their existence  – it was that they were required to be extinguished over a fairly swift timetable, placing unbearable strain on an already  strained exchequer and that it was done to put a figleaf on the notion that Anglo was a going concern.

Were these or national equivalents to be created by the national authorities of the core, we could well imagine much longer periods for extinguishing being placed in play.  If the Anglo ProNotes had been repaid over 300 years instead of 30 they would not have been an issue, except morally. While the numbers seem large, in the context of the (shrinking ) ECB balance sheet of 2.2b even the largest amount required is not unbearable. Part of the ECB objection to the notes was that the liquidity created was done so “outside its control”. A system of central banks cannot have individuals pursuing their own monetary policy in an uncoordinated and national focused way – that is what brought down the Rouble zone. But as a once off final fix for the banks? Its worth a shot.  In all probability the 750b would not be required in full. While the 40% fall over 6 months in equity values is high, this does not happen very often – but it does happen about 1 time in 25.   Doing this would ‘cure’ the banks, in so far as it would allow, in fact would have to be accompanied by,  a full write-down of impaired loans and thus position them for regrowth. It would allow a clean start to be made. Clean the mess up once and for all, and restart.

Alas, the inflation hawks and their fears  dominate the ECB, fears never more imaginary than now with deflation staring the Eurozone in the face, will not allow this. The consequence is that we flirt with a further crisis not merely knocking out the periphery but the core. As we have throughout the crisis we face a choice of unpalatable alternatives.  European banks will follow the irish lead – either via partial or full zombification with the odd twitch of life now and again while hoping that the economy does nothing remotely scary all the time barely functioning and taking a decade or more to get back to any health, or by the solution which worked, in that it allowed a bank to be cleansed and to br resolved.


2 thoughts on “Does An Irish Solution loom for European Banks (one way or the other) ?

  1. Roger O'Keefe

    Aren’t you understating the key role of banks, viz. creating new money out of nowhere?

    That’s where all the mystery religion stuff arises.


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