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Friday, July 6, 2012

How to rescue banks

Of the various bank rescue plans which I could witness during my career, the most effective one was the one which the Chilean government implemented in the early 1980s. While I do not remember all the details, I will apply below the general principles of that plan to the present situation of the Eurozone's banks.

First, one needs to understand that every bank has an "earnings power". By that is meant that every bank is profitable before provisions for risk and payments of taxes. Why is that so? Because by definition, banks lend at higher rates than they pay for deposits and they charge fees for their services. In blunt language one could say: banking is a business for idiots. You can't lose money unless you enter poor risks. Regrettably, the business of banking is entering risks...

Take as an example the consolidated financial statements of EFG Eurobank for 2011. They reported a net loss of 5.496 MEUR. Nevertheless, they still had an earnings power of 1.128 MEUR which was the "profit from operations before impairment on loans & advances and non-recurring valuation losses and before taxes". Put differently, if Eurobank had not had any risks to provide for and no taxes to pay, they would have had a profit of 1.128 MEUR. To makes things easier, I will now refer to Eurobank's earnings power as the rounded-down figure of 1 BEUR.

The recipe for a bank rescue is: take the total size of the problem, divide the annual earnings power into it and then you have the number of years which you need to solve the problem. Eurobank reported roughly 60 BEUR as "loans and securities" (i. e. the classical risk categories). Suppose half of that amount, i. e. 30 BEUR, would be bad. Net result? Eurobank would need 30 years to solve its problems out of its own resources.

The major problem of financial markets today is that banks' balance sheets show inflated values of assets and, therefore, banks don't trust each other because they don't know the risks of the counterparty. Please note the following rule how confidence returns to financial markets:

CONFIDENCE RETURNS TO FINANCIAL MARKETS ONLY WHEN THE BALANCE SHEETS OF BANKS REFLECT REALISTIC VALUES AGAIN. THAT MEANS EITHER BAD ASSETS HAVE TO BE WRITTEN DOWN TO REALISTIC VALUES OR THEY HAVE TO BE TAKEN OFF THE BOOKS OF THE BANKS.

Suppose the bad assets (including questionable sovereign paper) in Eurozone banks total roughly 4 trillion Euro and the banks concerned have a combined annual earnings power of 200 BEUR. I do not know how close these figures are to reality. My guess is that the problem of 4 TREUR is a bit of an overstatement and the annual earnings power of 200 BEUR is a bit of an understatement.

In consequence, it would take these Eurozone banks 20 years to solve all of their problems through their own earnings power. All they need is a third party which assures them that they have 20 years' time and this is where governments come in. The rule which applies to governments is "we have the time if you have the money". How would this work?

The EU would form a Special Purpose Vehicle (SPV). This SPV would purchase from the banks all the troubled assets at book value (i. e. the 4 TREUR as above). The SPV would fund itself through the issuance of 20-year bonds. Those bonds would be guaranteed by all Eurozone countries jointly and severally. There is no worry to be had about this risk which the countries are assuming because the guarantee will never need to be called on. The worst thing that can happen is that one needs, for example, 30 years of earnings power instead of 20 years but as long as there is an annual earnings power, there will be repayment.

There are only 3 principle conditions which must be complied with: the participating banks cannot pay dividends during the time that they are on the program; they must be exempt from corporate taxes and employee/management compensation must be approved by the SPV. Put differently, it must be assured that the earnings power is maximized and that all of it is applied to solving the problems. And then there is another requirement: the SPV has to figure out controls which assure that banks enter only into "reasonable" risks going forward.

What does that mean to the banks' shareholders? Well, initially the value of their shares is likely to go to zero because there will be no dividend payment for 20 years. Once the banks have solved their problems, the shares will regain value again. In a nutshell:

Existing shareholders must accept that they have lost the value of their shares but they can have the realistic hope that their children and/or grand children will be rich again.



ADDENDUM 07.07.2012
In Chile, it turned out that the SPV-program lasted significantly shorter than originally calculated. Why? Because the original calculation must assume that none of the problem assets transferred to the SPV will ever generate any paybacks whereas is actual fact they do. The larger the paybacks which they generate and the more the banks' earnings power can be increased, the shorter the stay in the SPV-program.

6 comments:

  1. Excellent. The fact that it is not happening this way, is telling about the leverage the shareholders have on the politicians...

    Bandolero.

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    1. Here is how the Chileans solved that problem.

      They made participation in the program entirely voluntary. Except that they alerted the bank managements and their shareholders of the following:

      Those banks which did not participate would be left entirely "on their own". Should they run into any difficulties, they would likely have to declare bankruptcy. In that case, the government would temporarily nationalize them; the savers would not lose anything but the shareholders would lose everything without any hope for eventual revovery. And the bank managements might become exposed to suits for damages by shareholders for not having accepted a solution as long as they could.

      Was that blackmail? Not in a legal sense. In a legal sense it was just "good advice". But in practice it was, of course, blackmail. In my opinion very justified blackmail.

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    2. Yes, extreme situations call for extreme measures. The same thing was done by the greek gov to pension funds. They said "unite in one.Those who don't want to, should know that are on their own". The PSI was done in a similar way "either you partecipate...voluntarity to the haircut, or you will suffer bigger haircut if you don't". Although the greek PSI didn't solve anything, if anything busted the Cypriot banks too, but that's another story.

      Bandolero.

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  2. a nice pdf dealing with this topic

    http://ideas.repec.org/p/chb/bcchwp/104.html#author

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  3. your plan may work or may fail. i don´t know.
    i´m not sure, whether taxpayers will love your idea to create a 4 trillion euro bad bank.

    in general you argue "if a bank has an earing power of 1 billion a year today. it will also earn one billion in 30 years if there are low risks etc."
    it´s impossible to look 20 or 30 years in the future with a high level of certainty. there are too many uncertainties.

    you wrote "There is no worry to be had about this risk which the countries are assuming because the guarantee will never need to be called on."

    so such a guarantee is only for those idiots, who do not believe, that this 4 trillion SPV is without risks?

    i like your optimism....

    ReplyDelete
    Replies
    1. The 4 TREUR is full of risks! In fact, this plan suggests that the 4 TREUR are not worth a penny and that all of it needs to be re-earned through the banks' earnings power. In practice, this won't be the case because some of the 4 TREUR will certainly be paid; perhaps even a lot of them.

      Again, to understand: the guarantees will never be called on because the 4 TREUR are such good risk but, instead, because there will always be earnings power. Maybe not as much all the time as one would wish but there will be some. If there is a little less of it, one simply needs more time.

      Understood?

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