Resolving European Banking System All Together

Not surprisingly to my readers, I consider the de facto defaulted banking system and over indebtedness as the two real pains of Europe (and of the U.S. as well, just that the attention is on Europe right now). In other words, sooner or later the European banking system is going to be resolved in one or another way – let’s hope the resolution will be amicable.

A bit of background

Why I’m saying that the European banking system is de facto in default all together even though major banks are generally reporting sound capital ratios and often also strong earnings from their core businesses? In short: these sound ratios and strong earnings are the result of accounting magic.

What you basically need to do is to compare the total amount of money (cash and deposits) with the total amount of debt; this would give you a rough idea of the amount of assets to be written off eventually unless central banks are “printing” us out of the debts with the cost of hyperinflation. Unfortunately, the exact comparison cannot be done easily (if at all) because much of the debt is off-balance or hidden as a result of securitizations etc.

For an illustration, though, you might consider the balance sheets of Swedish banks, for example: differently from many of their European peers, they usually have loans on-balance (at least when it comes to their Swedish operations). What we see, is a loan-to-deposit ratio around two, meaning that there is twice as much debt as there is money.

How did we come to this point? Well, pyramid-like schemes always look great before they collapse. Re-financing practices, re-structuring and various securitisation schemes by definition create debt without creating money.

Are the banking regulators sleeping?

Believe me they are not even though some may blame them for doing so (a la: how much does it take to manipulate interest rates?). If banks fail, the regulators fail, and they do not want to be declared as failed.  

It may have remained unnoticed for you because legal texts always look boring, but the European authorities are making their first hesitant steps towards resolving large European banks. On 6 June 2012 the European Commission announced the draft version of EU framework for bank recovery and resolution.

In short, they are suggesting a three-stage approach:

1. Prevention: all major banks will have to draw up recovery plans; authorities will need to prepare options for resolving banks in crisis.

2. Early intervention (foreseen when a bank does not meet or is likely to be in breach of regulatory capital requirements): authorities could require implementation of any measures set out in the recovery plan, drawing up a plan for restructuring of debt with bank’s creditors etc.

3. Resolution powers and tools (foreseen if the preventive and early intervention measures fail to redress the situation from deteriorating to the point where a bank is failing or likely to fail), incl.: the sale of business tool, the bridge-institution tool, the asset-separation tool and the bail-in tool.

I’m not going into details here; you might better take a look to the original text on the European Commission’s web page (click the above link or see: European Commission > Internal Market > Banking > Crisis management).  

In summary: well, one needs to start from somewhere... At least some of the necessary background research gets done and the idea of resolving the banking system is not that unthinkable any more. Of course, getting around the legal nuances and dealing with the various vested interests is taking awfully long. Furthermore, the massive debt problem still appears strongly underestimated, let alone the fundamental flaws in the very design of the monetary and financial system.  

Re-solution of European Banking System

The right way would be to move the entire European banking system to stage (3) of the above described bank recovery and resolution framework at once instead of waiting until a bank is being identified as “likely to fail”. In other words, instead of looking for possibly insolvent banks, we should look for the banks or parts of the banks that possibly could be solvent. Indeed: why should the banks that have been smarter in implementing dubious practices, be preferred to those who have been caught just a bit earlier?

The recovery and resolution framework stresses the importance of certain vital services that the banks are providing to citizens, businesses and the economy at large, such as: deposit-taking, lending, and the operation of payment systems. Even though I do not think that having banks as we know them is the absolute necessity, we might take these core functions as a basis for identifying the banks or parts of banks that need to be saved for today.

Roughly speaking, the steps for re-solving the European banking system would be the following:

1. Consider all banks as “failed” by default; let them come up with their own recovery and resolution plans; simplify business models, and undo all of the obscure transactions and –schemes in the extent possible; convert debt claims to equity similarly as proposed in the so-called bail-in tool.

2. Sort out “good banks” and/or the good parts of the banks (instead of focusing on creating “bad banks”) based on the so-called vital functions; ensure balance of the balance sheets of the good banks in terms of loans and deposits, liquidity and capitalisation, incl. take capital from the non-core functions of the banks, write off excess debts and, in the extent absolutely necessary, consider additional measures such as “eHarmony for the good banks” (I mean, mergers and acquisitions) or the use of the deposit guarantee schemes.

3. Wind down the rest of the banks if insolvent; if still solvent allow them to operate as normal businesses for which normal insolvency procedures apply.

Obviously, there are plenty of operational and legal issues to be considered. I’m sure, while drafting the new regulatory frameworks many of those have been carefully explored already by the banking regulators or still have to be dug into anyway. 


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