Zombie banks Scandinavian edition and the threat of too big to fail

Across the world, governments are doing their level best to shore up weak banking systems in the wake of the most significant final crisis in decades.  Most market players appear to believe these efforts successful; why else have shares risen so dramatically from lows late last year and early this year?

While I do believe the efforts have indeed been successful, I am far from certain they have addressed the underlying problem: large quantities of unrecoverable debt from reckless lending.

Witness the most recent bank merger in Scandinavia between Nordea and Fionia Bank.   This event seems to have gone largely unnoticed outside of Scandinavia. But, the core issues of socialization of losses, zombie financial institutions, unrealized loan losses, and too big to fail institutions are the same ones at work in the U.S., the U.K., Switzerland, France, the Netherlands, and many other countries.

While all is fine and good in an environment of economic recovery and rising asset prices, there remains a lot of downside risk were we to face a renewed slump in the global economy.

Socialization of losses

Fionia is a failed bank in Denmark about which I wrote in February. The bank collapsed after taking large writedowns early this year.  However, the Danish government was loath to liquidate the institution. Instead, it transferred the assets of the bank to a new Fionia Bank, which it has just sold on to Nordea, the large Scandinavian giant.

You should notice two things about this transaction. First, the price is quite low: Nordea has acquired Fionia for $173 million. This pales in comparison to the well over $200 million writedowns Fionia took which caused it to fail.  Moreover, the Danish government subsequently pumped another $169 million into the bank in order to sanitize it for sale.

I have not seen any details of the saleregarding further contingent liabilities for the Danish taxpayer. But, to my mind it strikes me as similar to recent FDIC seizure/sale agreements for BankUnited and Guaranty, where the government took the lion’s share of losses and flogged the remaining assets off for a low price to a willing buyer.

Zombie financial institutions

But, then you have the zombie bank problem. The term ‘Zombie Bank’ was popularized during the S&L crisis by Edward Kane to connote banks which continued to operate but only as a result of government largesse as they were effectively insolvent.

Nordea had a very fine second quarter in which it showed net income of over 600 Million Euros. The Danish daily Berlingske Tidene even called the first half “one of the best in Nordea’s history.” But, how healthy is Nordea really?  It will weather the storm but the company has large residual exposure to unrealized losses in the Baltics.

More to the point, Sweden’s central bank, has lowered interest rates to effectively zero. This allows any financial institution in trouble to make a large gain due to interest-rate spreads (borrowing for much less than lending) or the carry trade (borrowing short and lending long). The Riksbank is actually running negative interest rates by charging banks to hold funds on deposit. Clearly, banks now have every incentive to lend and this will support the economy as long as rates remain low.

But, it’s not like those unrealized losses magically disappear.  The toxic assets are still there.  Asset price inflation makes them appear to become much less toxic.  But what happens when the economy in Sweden turns down or asset prices fall?

That’s when day turns to night and the zombie banks come out of their holes and terrorize the town.

Too big to fail

Flogging Fionia off on Nordea is a lot like having JPMorgan Chase buy Washington Mutual.  It only makes the acquiring company larger and more dangerous – too big to fail and too big to bail (out).  It is not a very good solution. Just ask Iceland.

By now you have seen David Cho’s piece in the Washington Post analysing this very problem in the United States.  He writes:

When the credit crisis struck last year, federal regulators pumped tens of billions of dollars into the nation’s leading financial institutions because the banks were so big that officials feared their failure would ruin the entire financial system.

Today, the biggest of those banks are even bigger.

The crisis may be turning out very well for many of the behemoths that dominate U.S. finance. A series of federally arranged mergers safely landed troubled banks on the decks of more stable firms. And it allowed the survivors to emerge from the turmoil with strengthened market positions, giving them even greater control over consumer lending and more potential to profit.

J.P. Morgan Chase, an amalgam of some of Wall Street’s most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued and -owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show.

But this is not just an American problem. It is a systemic problem that affects Europe even more. Look at the list of the top twenty-five European banks by asset size. Almost every Western European country is plagued by the Icelandic problem of institutions that are too big to fail, but too big to rescue.

In fact, Denmark is near the top of my list with one institution, Danske Bank, having assets nearly 200% of GDP. Were I to have added Sweden to this list, they would come in ahead of Denmark with four banks having assets of over 300% of GDP. (Nordea – 2008 assets: 474 billion euros, SEB – 213 billion euros, Handelsbanken – 212 billion euros, and Swedbank – 179 billion euros.

Germany is taking the lead on putting an end to too big to fail – or at least solve this problem on a global basis. Peer Steinbrück, the German finance minister, is trying to force the G-20 to agree to “international rules that facilitate the insolvency and liquidation of large, internationally active banks.”

Concluding thoughts

Felix Salmon suggests a surcharge on bank size.  The idea is that taxing banks, penalizing them for becoming to large, one can use a more free-market approach to curb these institutions.  I like the idea, but I do think more will be necessary.  The bank size surcharge is one most banks would willingly pay if it means in good times they can pocket more excess profit in good times than the tax penalizes them.

And it is good times that are important. if the Federal Reserve and other central banks continue to lower interest rates to extremely low levels, banks will extend credit recklessly in good times because of a false price signal the interest rates display. Only when a downturn takes place will banks recognize they have over-lent and that the size surcharge was not a good bet.

I am sceptical that anything meaningful will come of Steinbrück’s plan in an environment were everyone is talking about economic recovery.  The urgency seems to have passed. But, the threat posed by toxic assets and by megabanks has not.

Note: Originally, this article stated that Nordea had ‘huge’ exposure in the Baltics.  This has now been changed to ‘large’ and I have added the line ‘It will weather the storm.’ I do believe that Nordea is the best-positioned of the large banks headquartered in Sweden.  They are the best bank to take on a Fionia Bank. However, I am using their acquisition of Fionia as a vehicle for a larger discussion about acquisitions like this to talk about too big to fail.