Kicking the Can: The Issue of Bank Capital

In the last quarter century, each and every time politicians have “kicked the can down the road” in order to buy time to protect their banks (with the false hope that there will be a “Deus ex Machina,” i.e., a miracle), the resulting pain is much worse than if the problem had been addressed head on and resolved, even if painful at the time.  You can look at this in many ways, including the deficit and entitlement issues in the U.S.  But, I am going to limit myself to the financial realm in this particular essay.

Kick the Can: The S&Ls

In 1984, I gave a presentation to a group of senior citizens regarding what I saw as the insolvency of the S&L industry.  In social conversations, my wife often recalls the reactions of many of those seniors, many of whom had Certificates of Deposit at S&Ls (back then, interest rates were significantly higher than today’s paltry rates).  I suspect that the local heart specialists were busier than usual the next day.

The S&L can was kicked down the road for five more years.  It wasn’t until a new President (Bush #1) was inaugurated that the problem was addressed – that was 1989.  By then, the problem was significantly larger than it was in 1984 when even I could recognize the issue.  Because the can was kicked for five years, America went through an unnecessary and grueling recession in the early ‘90s, in which the financial system teetered and required government intervention.  Truth be told, however, the allowance of the S&Ls to abuse deposit insurance (or at least not appropriately pay for the risk they were layering onto the insurance system) and lack of oversight by the regulators (sound familiar?) should take much of the blame.  However, by ’89 the crisis was addressed, S&Ls were closed, and the bad loans on their books were dealt with.  Because the bad loans were written off, the financial system stabilized and enabled the economy to grow and prosper for much of the rest of the decade.

Kick the Can: Japan’s Banks

At about the same time (1989) Japan’s bubble burst.  In 2002, then Fed Governor Bernanke, criticized the Japanese approach to their banking issues in a famous speech about how the Fed would not let a Japan style deflation happen in the U.S.  Beginning in 1989, the Japanese regulatory agencies did not, and to this day, have not required Japan’s banks to recognize the losses on their underwater real estate loans.  When banks get into a position of knowing they have problem assets, they become quite reluctant to expand their loan portfolios and take on new risk.  Oftentimes, the regulators, recognizing that they have dropped the ball in the first place, become overbearing and shackle the banking system.  More than two lost decades later, Japan’s real estate (land) prices are still falling, and economic growth remains sluggish, intermixed with frequent bouts of recession.

Kick the Can: Too Big To Fail

The financial crisis in the U.S. in ’09 was also met with can kicking.  The “Too Big To Fail” (TBTF) banks that were allowed too much leverage in the period leading up to the crisis were all saved with taxpayer dollars. This time, however, the problems were not met head on as they were in ’89.  In fact, Dodd-Frank has now codified TBTF – those institutions are now called SIFIs, Systemically Important Financial Institutions.  And, America’s banks are back to playing the leverage game, this time with complicity from Washington, which depends on them to purchase newly issued debt.  By the way, that debt requires no underlying capital, an issue we will see later in this essay that has come to the forefront in Europe.  In the ’09 crisis, the shadow banking system (non-deposit taking lenders) was destroyed, and because the remaining small business lenders, America’s community banks, still have major asset issues, small business lending has dried up.  Today, as in Japan, economic growth is sluggish and the economy continuously flirts with recession. (I can’t blame all of the sluggishness in small business lending on the supply side because clearly the demand for small business loans is down due to the uncertain economic outlook that pervades America today.)

Kick the Can: Save the Bondholders

One major mistake of Japan, and of the so-called solution to the ’09 financial crisis, is that bondholders of most of these failing institutions, who took the risk of their investments, have not been asked to take the losses.  Except for FNMA and FHLMC, even the preferred shareholders of the failed megabanks (Wachovia, Washington Mutual, Merrill Lynch) were saved.  Why was it so important to save these stakeholders?  Did we really fall for the concept that if their bondholders lost money, then the economy would totally collapse?

Kick the Can: European Bank Stress Tests

Today, Europe’s banks are teetering on the edge.  This past Spring’s round of “stress tests” were a joke meant only to assuage the markets.  The sovereign foreign holdings of Greek, Irish, Portuguese, Spanish and Italian debt were all counted at par with zero capital required against these assets.  It is clear that the European banks are in desperate need of capital, and the shutting down of calls for such capital from knowledgeable and respected individuals doesn’t really fool anyone.  So, why are the Europeans about to throw good money after bad in a futile attempt to keep Greece from defaulting, and, once again, kicking the can down the road?

By forcing further “austerity” on the Greek economy in order to give them enough aid to pay the upcoming round of bond maturities at par, and therefore “saving” those particular bondholders, they are just prolonging the whole issue.  Even more austerity will further undermine the Greek economy causing ever widening deficits.  So, why are the bondholders so sacred?  The answer, of course, is that the European banks hold huge positions in the sovereign debt of Greece and the other high debt European Monetary Union (EMU) nations.

Kick the Can: Liquefy European Banks

With huge volumes of such debt on their books, each financial institution has become leery of its brethren, and interbank lending has begun to dry up.  As a result, The Fed, the European Central Bank (ECB), the Swiss national Bank, the Bank of England, and the Bank of Japan, in a coordinated effort in mid-September, began making dollar swap lines available to the European banks.  It appears that the Fed is involved because of Bernanke’s view of the Fed as the world’s central bank, and because of the fact that the vast majority of America’s money market funds hold large amounts of European bank commercial paper or other debt as assets.  Thus, instability of the European banking system could potentially touch off another credit market freeze in the U.S. and worldwide.  Yet, despite these interventions, within a week those very same liquidity strains have begun to re-emerge.

Kick the Can: Greek Default Inevitable

In the end, a Greek default is inevitable.  The math on this is too compelling.  Even if Greece could balance their budget pre-debt service, the debt service cost alone, even at reasonable interest rates, doom them to years of depression.  For Greece, default is really the best road.

Default is also better for the rest of the EMU.  Better to use the funds that are now going to pay off bondholders of Greek debt at par to help recapitalize Europe’s banks.  In the long run, this is cheaper and it addresses the underlying issue, European bank capital.

As for Greece, they, and even the other weaker EMU countries, can go back to their own currencies, and, if they so choose, peg them to the Euro.  If they run large fiscal deficits, the pegs can always be adjusted.

Dealing with Greek Default

A Greek default, of course, risks a financial panic in the markets.  To deal with such contagion, the ECB or the EFSF (European Financial Stability Fund) or some pan-European or international entity with credibility, should specify which countries are Tier I EMU countries, which are Tier II (Italy and Spain),and which are Tier III (Greece, Portugal, Ireland).  Tier III countries should be planning an imminent, but orderly, exit from the EMU with ECB and EFSF support of their bonds at some price well below par.   Tier II countries should be given some time and support (in the form of an ECB or the EFSF bond purchase program at par) to get their fiscal houses in order.

The inevitable Greek default is going to have a worldwide impact even if done in an orderly, thoughtful, and coordinated way. (If not planned properly, expect very high volatility in the financial markets.)  And financial institutions in the U.S. will not be spared the effects of such a default.  If the European banks appear in danger, U.S. money market funds, and very likely some of the SIFIs with loans to European banks, will be hard hit by market action.  We have already seen the beginnings of this.

More Capital – the Reason for Basle III

It should be obvious by now that many of the largest worldwide banks need more capital.  Yes, even those in America.  (Consider the recent BAC denial of its need only to obtain capital within a week of the denial!)  The need for capital is why we have Basle III.  Unfortunately, the Basle III timeline is too lengthy, as the capital is needed now.  Without new capital, much of the developed world will suffer the fate that Japan has suffered over the past two decades and now present in the U.S., with banks too worried about capital levels to want to take on additional risk in the form of business loans.  Well-capitalized banks at least remove the constraint of loan availability when conditions are right for economic growth.

Robert Barone, Ph.D.

September 26, 2011