Europe will need to accelerate implementation of its bail-in and bank resolution scheme

As I wrote regarding the Spanish bank bailout just now, large losses at European financial institutions likely mean that equity will be wiped out. Government will then need to decide how the losses will be paid for. In Spain’s case, the problem is that the new Rajoy austerity program has begun a debt deflationary path that is iteratively negative between income, consumer spending, debt affordability, asset prices, and bank balance sheets. My sense is that Spain is now in a Greek-style death spiral rather than the relatively less painful Irish depression that policy makers are hoping for. Losses are going to increase dramatically in that case and so bail-ins become important – but, not just in Spain.

I talked a bit about this at the end of the post on Spain but I want to tie a few other threads together here.

The US banking system faced all of the same problems that Spain is now facing when it went through the 2008-09 crisis. And while I believe another recession will bring many of the same problems back, the US has gone much further than most anywhere in Europe in recapitalising its banks. A good place to start in reviewing the different options- bail-in, nationalisation, bailout – is the video where Bill Ackman and Joe Stigliz talk stress tests with Charlie Rose in April 2009.

I like the bail-in idea a lot and this is being implemented as part of the coming European bank resolution scheme which will be operative beginning in 2018. I will get to that shortly. But here’s where the sticky wicket is. The Wall Street Journal writes about the discussions ongoing at the European Finance Ministers’ meeting right now:

In contrast to direct bank recapitalizations from the euro-zone bailout fund, this proposal still expects national, and eventually industry-funded, resolution funds to do most of the heavy lifting.

Those limitations, however, are unlikely to make agreeing on the proposals any easier. The resolution plan could fundamentally reform the way governments—and the European Union—deal with banks that run into trouble. Once the new rules kick in on Jan. 1, 2018, shareholders and unsecured bond holders may well be wiped out before any public money is used to preserve their most vital functions. And that prospect, even years away, won’t make it any easier for capital-deprived banks to find new funding even now.

Basically, European national governments, as currency users, have limited capacity to bail out financial institutions. So creditors need to pony up. Having them do so creates funding problems, not just for the insolvent banks but banks more generally. That issue is one I discussed after Ireland hit the wall in 2010 and was bailed out in 2011. I wrote up how the Irish can prevent a bank crisis from becoming sovereign default in allowing sub debt holders to take haircuts in November of 2010 but the issue is more complex than that. The Swedes gave a blanket guarantee to bondholders for fear of the new funding issue.

Reviewing the situation this March, I wrote:

The issue is separating liquidity and solvency. In a systemic crisis, the illiquid can be rendered insolvent. So, a credible senior bondholder guarantee can underpin the capital structure of a solvent organization and induce investors to roll over debt. That’s why the Swedes guaranteed senior bondholders in the 1990s. As I put it then: "To my mind, this all speaks to the overriding need for policy makers to ascertain who is illiquid and who is insolvent and to as demonstrably as possible subject the insolvent and the solvent to the most differential treatment one can muster."

Bottom line: I side with the Irish journalist in the video below. He is rightly indignant that the Irish didn’t take the Icelandic route. That the Irish risked bankrupting the state was obvious almost from the beginning of the crisis. There is ZERO reason for the Irish people to bail out foreign creditors of a DEFUNCT Irish bank. The Irish government should repudiate their obligation to these bank debts as I have said many times before. Nonetheless, there is a kernel of truth in what Masuch says. The reality is that the Irish government had to make a difficult decision in determining whether to go the Swedish route or the Icelandic route. I think they made the wrong decision.

In Spain, while the banking system is much bigger, it is smaller relative to the country’s GDP; so some form of senior debt guarantee like the Swedish one is not out of the question. Karl Whelan takes the opposite view and presses hard for senior bail-ins/writedowns in an article at Forbes that I quoted in the last piece. Whelan writes:

The other issue relating to Spain relates to senior bondholders. These bonds generally contain clauses ranking their claim equal with those of depositors in the event of a wind-up of the bank.  In reality, court-ordered bank wind-ups tend not be a practical outcome.  Moreover, the existence of deposit insurance schemes means that states have already chosen to treat depositors differently from bond-holders should a bank get into serious difficulty.

These considerations mean that the way to save public money when a bank gets into serious trouble is the introduction of a resolution regime that allows for deposits moved to a different institution and senior bond-holders “bailed-in” via debt write-downs or the conversion of their claims to equity in what remains of the bank.

Should Taxpayers Bail Out Spain’s Bank Bondholders? – Forbes

Whelan goes on to say that European governments simply do not have the funds to recap these banks without bail-ins irrespective of their desire not to "spook the market" by writing down bond debt. What he says makes sense, especially given banks have larger balance sheets in Europe because of the lack of disintermediation by bond markets which have taken a lot of assets off of US bank balance sheets. So I have to conclude that Europe will eventually need to accelerate the bail-in portion of their resolution scheme. If Italy gets into trouble this will create difficulty as Italian banks have also cajoled depositors and retail customers into non-deposit funding similar to what we see in Spain.

What kinds of bail-ins could we expect? A Spanish economist wrote a good outline for the Wall Street Journal last month. Here is an extended quote giving you a sense of the magnitude of the capital shortfall as well as the mechanism to put in place:

the Spanish state, with its own deficits and official unemployment of 25%, cannot afford to save the banks, even with the help of a soft loan from Brussels. This is the clear message from the markets at least.

Fortunately, there is a better solution for Spain’s banks: Instead of a bailout, the Spanish state should force a "bail-in," in which all of the banks’ subordinated debt and some of its senior unsecured debt is converted to equity. This would reduce the banks leverage and increase the capital available to absorb the coming losses.

First of all, consider the grim fact that even €100 billion may not be enough to put Spain’s banks back on their feet, as they could easily face losses of perhaps three times that amount: Real-estate loans amount to €298 billion, construction credits to €98 billion, mortgages to €656 billion and other loans for families and firms to €683 billion. Assuming a 50% loss in real-estate and construction loans, a 5% loss in mortgages and a 10% loss in other credits to the national private sector, brings us quickly to the worrying figure of €300 billion in losses. And don’t forget the banks’ additional exposure of €78 billion to Portugal and €10 billion to Greece and Ireland, which could add losses of between €40 billion or more to our calculation.

Spanish banks currently report total equity of €377 billion, so losses on this scale would leave them with just €50 billion to €70 billion in remaining equity. To bring them back to reasonable levels of capital would then require €150 billion to €170 billion—well above the €100 billion line of credit that the EU plans to offer. Thus, even if the Spanish government chose to borrow the full amount on offer, national banks would still be undercapitalized by an amount equivalent to two or three years of their pre-provision operating profits.

[…]

Converting into equity 100% of the €88 billion of subordinated liabilities, and 40% of the €160 billion of senior unsecured debt, would generate more than €150 billion of loss-absorbing equity for the Spanish banking system. Together with the estimated €25 billion in expected operating profits for 2012, before loss provisions, that would yield about €175 billion in new bank equity, without increasing the debt burden of the Spanish taxpayer or requiring a loan from Brussels.

In other words, there is a solution to the problems facing the Spanish banking system: not a bail-out, but a bail-in, whereby investors bear the vast majority of the cost of their own mistakes, without liquidating the banks and without pushing the Spanish economy into bankruptcy.

Certainly, a compulsory bail-in may initially cause some turmoil in interbank lending markets. But since the beginning of 2012, Spanish bank financing has already relied heavily on liquidity provided by the European Central Bank. After some time, short-term credit would flow again inside a country with much more robust and solvent financial institutions.

My suggestion is that preferreds be converted first, wiped out if the capital is insufficient before moving to the debt holders. The debt holders should have an option of writedowns or equity conversion especially because some debt holders from funds are specifically limited in the types of investments they can hold. And senior debt is the stickiest wicket because haircuts here could create contagion. Nevertheless, the outline here is clear: set specific guidelines on how much bailing in one can anticipate will need to occur and this will go a long way toward relieving market funding worries for euro banks.

To the degree that Europe devises a bank resolution scheme along these lines, they will need to use it because bank recapitalisation will be an issue outside of Spain as well.