Saturday, 9 June 2012

How to bring down a bank

This, from a comment on Richard Murphy's blog.
a. If the EU lends money to the Spanish government it presumably then lends it to the banks.
b. According to orthodox theory every debt liability has a corresponding asset
c. If that is true the worst that can happen is that the transaction is neutral so far as Spain is concerned
d. It seems possible that it could actually reduce sovereign debt depending on the interest charged on the loans to the bank
e. When Europe lends to a state it imposes conditions
f. It follows that if a state lends to the banks it can equally impose conditions
g. The state can therefore require that the banks use the money to repay deposits from ordinary people and money owed to pension funds
h. After that the banks can go hang, because it is those liabilities which blackmail us into helping them
i. That money is then with depositors and pension funds
j. The state can then require them to give it to the state for use in rebuilding the economy
There are numerous problems with this.

Firstly, the commentor confuses debt and capital. The Spanish caja banks are short of capital. That means that their debt is too high in relation to their assets.  The gap between assets and debt on a bank balance sheet is its capital. If that gap becomes too small, the bank may be unable to repay its creditors in the event of its assets losing value. Bank creditors are depositors, bondholders and other banks.  Borrowing from other banks, including central banks, is collateralised - banks have to pledge high-quality assets, typically government bonds, which will be forfeited to the lender in the event of them being unable to repay the borrowings. Obviously, then, having insufficient capital puts bondholders and depositors at risk: the smaller the capital base, the more likely it is that bondholders and/or depositors will lose their money. If the gap inverts - debts exceed assets - then the bank is insolvent.

Clearly, lending to a bank that is short of capital doesn't solve its problem - it makes it worse. So the Spanish government isn't going to borrow money from the EU to lend it to banks, as this commentor thinks. It's going to give it to them. In return it will own part of the business (partial nationalisation). This is called an equity stake and it is a balance sheet asset for the holder. So the money borrowed from the EU - a debt liability for the Spanish sovereign, as the commentor correctly notes - would be balanced by an equivalent equity holding in the Spanish caja banks. There is in my view therefore no need for the EU's loan to be included in net sovereign debt, and there is precedent for this exclusion: the UK's net national debt figures do not include the additional borrowing needed to buy its stakes in RBS and Lloyds.

However, there is little or no chance that this equity stake could reduce sovereign debt, at least in the short term. There is no interest charge on equity. There may be dividends, but a bank rescued in this manner would be unlikely to pay a dividend for quite some time after bailout. In the longer term, any gains from share price movements could eventually be realised by selling the stake - although this is by no means certain: the UK made a loss when it sold Northern Rock.

So, having made the Spanish banks' problems worse by lending them the money instead of taking an equity stake, our commentor then wants the Spanish sovereign to direct the banks to use the money to eliminate their depositor base and redeem senior bonds. Well, I suppose that's one way of eliminating the problem that lending them the money would cause.  But it kind of defeats their purpose. These banks are SAVINGS banks. If they repay savers all their money, they aren't savings banks any more, are they? And the banks would still be short of capital. It would just be EU taxpayers' money at risk instead of Spanish depositors and bondholders. And all lending would have to be funded from interbank lending - most likely from the Spanish central bank.  In effect the cajas would become state lending conduits: private savers would be forced to move their funds elsewhere and all money for lending would come from the Spanish government, directly or indirectly. And as borrowing from central banks is collateralised, the banks would need copious quantities of, er, Spanish government bonds. This arrangement would almost certainly break EU rules forbidding central banks to fund governments.

But suppose our commentor agreed with me that actually an equity stake is required? Things then become even sillier. Having providing the banks with capital, to protect depositors and bondholders, the Spanish government then insists that the banks repay depositors and redeem senior bonds. Thereby eliminating the whole point of providing the capital.

Pointless though it seems, what would actually happen if the Spanish government did this? Governments have done stupider things than this, after all.

Well, actually the same as if the Spanish government had lent the money. Savers and bondholders would be forced to move their money elsewhere and the banks would become totally dependent on the Bank of Spain for funding, for which they would need Spanish government bonds. We are back to government lending conduits and direct financing of government by the central bank, aren't we?

At which point the EU arrives on the doorstep to take over the whole shooting match.

Oh, and those savers and bondholders wouldn't have to decide where to put their money once the banks have repaid them. No, the Spanish government should "require them to give it to the state for use in rebuilding the economy". Presumably, therefore, for lending out by those same banks from which they were forced to remove their funds. There's a word for that action: it's called expropriation. Otherwise known as "theft".

This is an object lesson in how to bring down not one bank, but an entire national banking system.

To be fair to the commentor, she did climb down over some of this after I replied. But it just goes to show what very muddled thinking exists out there.




4 comments:

  1. Lessons From Voltaire, Enlightened Economist

    Great writer was also successful businessman, admirer of Adam Smith, student of high finance. He lent to princes, and did well from it. He advised governments to borrow only from their own people, not from foreigners | Patrick Neiertz & Nicholas Cronk | FT

    Note "He advised governments to borrow only from their own people, not from foreigners"

    ReplyDelete
    Replies
    1. And one would hope that the people would want to lend to their government rather than to foreigners, too. But that depends how much they trust it - which is back to my post "When trust is broken", isn't it?

      Delete
  2. Dear Ms Coppola,

    I have a quick note to you on a different topic - but I do not use twitter and hope you do not mind me writing to you via your blog.

    The news concerning the renewed opening of discussions re the eurozone treaty between the German coalition and the German opposition do not concern the ratification of the ESM, but the ratification of the fiscal pact. In fact, I woud be very surprised if the German opposition were to challenge the ESM, which they support wholehartedly.

    Thank you for your time!

    Yours sincerely,
    one of your blog roll readers in Germany

    ReplyDelete
  3. Thank you. That does indeed need to be made clear. I'm glad you've pointed that out.

    ReplyDelete