Thursday, June 27, 2013

EU Transforms Depositors into Hedge Fund Investors!

This post relates to Greece only in the sense that Greece is presently completing a restructuring of its banks. The way I understand it, it is not a restructuring which I would support (the NYT writes that some of the major beneficiaries will be those bank managers and owners who had run their banks into the ground).

To be sure, I definitely feel strongly that it cannot be the tax payers who always pay the bill for bailing-out banks which have acted irresponsibly. Thus, I share the EU's objective but I disagree with the proposed implementation. First, my most important point.

No bank can ever be completely safe but depositors put their money into banks and not hedge funds because they have the reasonable expectation that banks are safer than hedge funds. Thus, it is the primary responsibility of governments and/or banking authorities to implement banking regulations which can be deemed to make banks safer than hedge funds.

Basel-3 stipulates that, in addition to minimum capital ratios as per risk-weighted assets, banks must maintain a minimum equity/total assets ratio of 3%. Banks like Deutsche or BNP today have an equity/total assets ratio which is closer to 2% than to 3%. Mind you, this is the on-balance sheet ratio. If off-balance sheet items were included, the ratio would be even lower. A 2% equity/total assets ratio means that a bank has total assets of, say, 100, total debt of 98 and total equity of 2. Should all the assets depreciate in value by only 2%, all the bank's equity would be wiped out.

A 2% equity/total assets ratio is equivalent to a leverage of 49:1. If off-balance sheet items were included, the leverage would be accordingly higher. A hedge fund with a leverage of 49:1 would be considered a very highly-leveraged (high risk) hedge fund. Typical depositors would never put their money into such a high-risk venture. Instead, they put their money into a bank thinking that a bank, while never completely safe, will be much, much safer than a hedge fund. Are Deutsche, BNP & Co. safer than a hedge fund? The numbers would suggest, no! They are only safer in the sense that they can still count on the implicit guarantee of their governments.

So, the EU is essentially saying to depositors: "We know that policy makers have allowed large banks to become as risky as hedge funds but, sorry, if those bank-hedge funds fail, you have to foot part of the bill!" The depositor who wants to put his money into a large bank which is safer than a hedge fund won't find one. The depositor has essentially been transformed into a hedge fund investor (except for the fact that, with a bank, he has the first 100 TEUR insured by the government whereas with a hedge he has no insurance at all).

This is nothing other than focusing on repair instead of prevention. A focus on prevention would require to first make banks safer than hedge funds and then require savers to pay part of the bill in case of failure (which failure is then less likely).

The book The Bankers' New Clothes, the authors argue that there is absolutely no reason not to require banks to increase their equity/total assets ratio to 15-20%, at least. That would still not guarantee that there will never be bank failures but it would definitely increase the bank's cushion which is available to absorb losses.

A courageous position on the part of the EU would have been to say something like the following: "We recognize that many of our large banks are hopelessly undercapitalized. We will require banks to increase their equity/total assets ratio to 15-20%. Until they reach that level, banks will have to discontinue paying out dividends and bonuses will be subject to review/approval of the respective national banking authority". That would send the right message across.

The other question which is not clearly addressed in the EU's proposal is: who determines (and how?) when bank failure has occured and the liability chain comes into force? Clearly, a really bad bank has to be closed right away and bankruptcy laws make a new liability chain unnecessary. But what about all the other banks, particularly the TBTF-banks?

I would argue that if European TBTF-banks were required to make a 'true' mark-to-market excercise, few of them would still be open for business afterwards. Their exposures to the so-called risk-free assets (government bonds) is just too large to withstand the need for a write-down in the order of, say, 25%. Thus, it would theoretically be possible for authorities to declare banks like Deutsche, BNP & Co. as having failed and to set the liability chain in motion.

Moreover, if a bank is deemed as having failed on the day when it no longer can refinance itself in the market, the distinction between illiquidity and insolvency becomes blurred. In the case of HypoRealEstate, illiquidity was definitely tantamount to insolvency. What if BNP faced a temorary liquidity crisis? Would it be deemed to be insolvent right away?

In summary: there is a huge risk that the liability chain comes into force without a bank really having failed and before such a determination can be made. This would lead to the situation where existing depositors share in a loss which may eventually not be a loss at all, in which case the benefit goes - unjustifiably - to the new shareholders.

The final cost of rescuing a bank is only known when the rescue has been completed and the final tally is made. That normally takes years. To protect depositors from unjustly sharing in the damage, there should not be an immediate cut of their deposits. Instead, their deposits should be frozen until such a time when the final tally can be determined. At that point, they will find out whether perhaps they have to take no losses at all or perhaps lose a lot more than the proposed 8%.

1 comment:

  1. An alternative title could have been: "EU acknowledge depositors that banks ARE hedge funds" ?