The Wrong Way to Fix Europe’s Busted Banks
March 21, 2013
(This item originally appeared in Forbes.com on March 21, 2013.)
There’s a certain process that is supposed to happen when a bank becomes insolvent, as many banks are today worldwide.
The bank enters some form of bankruptcy, although this may be termed “receivership” or “nationalization.” The equity becomes worthless. Assets are written down to a reasonable estimate of their true economic value. Junior creditors take losses, and in some cases have a debt/equity swap.
In this way, the bank’s liabilities are reduced, thus resolving the issue of insolvency. This has been happening several times a week here in the United States, as the FDIC shutters one bank after another.
In principle, non-interest-bearing demand deposits are the most senior, and thus do not suffer losses until all the other creditors have a 100% loss. The bank does not require some sort of government “bailout”; this process happens entirely within the private sphere, although the government may intervene to expedite the process, particularly for larger banks.
The bank does not have to be liquidated. Normally, it continues as a going concern. Employees continue to show up for work. Branches remain open. The bank does not have to sell any assets. This is what has been happening in most FDIC-led receiverships in the U.S. in recent years.
This is the process that many in the eurozone — notably the junior creditors, especially other banks — want to avoid. Instead, they want the bank to be “bailed out” typically with enormous amounts of public funds. Where does the money go? In effect, it goes to pay the junior creditors.
Although the details are hazy, it appears to me that the eurozone leadership, heavily influenced by large banks, attempted to reverse this process in Cyprus. In effect, the depositors would take the first loss, and the junior creditors would be protected. That is likely why the situation was described as a “tax” which would fund a “bailout.”
This is total theft of senior creditors’ assets. No wonder they refused.
Such have been the promises of the eurozone leadership of late, that absolutely nobody will take a loss ever, that even the threat of the normal receivership of an insolvent bank threatens bank runs across the continent.
For one thing, all the junior creditors — often other large banks — would also have to take losses, which would put them closer to insolvency themselves. This process could lead naturally to a “bank holiday,” in which insolvent banks across the continent would be put into receivership, and liabilities restructured, simultaneously with government oversight.
This is not necessarily a bad thing. The result would be that the banking system would be solvent again. When the United States declared a bank holiday in 1933, the result was very positive, as people had far more trust in the banking system afterwards.
In 1933, U.S. banks reopened six days later. The Dow Jones Industrial Average rose 15.34% that day, its largest one-day percentage gain ever. People understood that the worst of the danger had passed.
No public money was needed. The whole process was budgeted at $2 million, not a lot of money even then, to cover administrative overhead. There was no “bailout.”
In 1933, the U.S. was already in an obvious crisis situation. The eurozone leadership still believes it can get by with a phony “business as usual” facade. The willingness to do something as dramatic as Roosevelt did in 1933 doesn’t exist yet.
If Cyprus is an example of the eurozone leadership’s “solutions” to its problems, things will likely drift further toward a hot crisis. The reason is simple: nobody is willing to fix anything until then.