The View

Failing banks must be allowed to fold before markets can regain sanity

Important lessons can be drawn from how euro-zone regulators managed, or mismanaged, this month’s failure and recovery of two European banks

PUBLISHED : Thursday, 15 June, 2017, 1:23pm
UPDATED : Thursday, 15 June, 2017, 10:49pm

It is impossible to accurately assess the fragility of the financial system during any given period. The history of financial crises suggests that the risks are the greatest after a long period of optimism.

The rapid expansion of credit relative to income or gross domestic product means that banks have taken on more risk. This accurately describes what happened during the 2009 financial crash and what China is trying to avoid. The entire behavioural and economic definitions of a bank run, liquidity and solvency become paradoxical.

China has not yet been hit by a systemic banking crisis, but how its regulators might deal with individual bank failures and runs will determine the policies that are key to its economic survival.

Increasing risk of banking crisis for China: international watchdog

Important lessons can be drawn from how euro-zone regulators managed or mismanaged this month’s failure and recovery in Italy’s Banca Monte dei Paschi di Siena and Spain’s Banco Popular.

The Italian government resisted a bail-in, which forces losses upon the banks’ debt holders and shareholders even though this is the stated and mandatory European Union directive. It fears that a bail-in might worsen the crisis as rumours of an impending bail-in might spread to other banks within the Italian financial system and incite panic among depositors and counterparties.

Only when EU regulators accepted the Italian government’s definition that Banca Monte was a going concern rather than insolvent was the state-supported Atlante fund able to inject the required 1 billion (US$1.1 billion). This constitutes a bailout at taxpayers’ expense.

By contradicting European Central Bank rules and effectively doing a bailout, Italy threatens EU unity as weaker member states will still be forced to use bail-in for bank recovery. And that could represent the tipping point from integration to disintegration.

The euro zone also faced a challenging test after Banco Popular drew down 3.6 billion of emergency central bank funding last week. The Spanish bank was inflicted with the euro zone’s first large-scale bank run. By Tuesday last week, it said it was unable to continue business without a rescue package to restore its weak liquidity.

“The reasons that triggered that decision were related to the liquidity problems,” Vitor Constancio, vice president of the European Central Bank, said on Thursday last week. “There was a bank run. It was not a matter of assessing the developments of solvency as such, but the liquidity issue.”

This remark highlights a fundamental misunderstanding of the nuances between bank solvency and liquidity in their haste to resolve the situation.

Regulators permitted a 2.5 billion rights issue for the bank just in June last year. And the Spanish economy is in better shape now than in 2016. They cannot claim “the economic scenario has affected negatively our assessment”.

And the bank had passed all the stress tests. Shareholders’ equity was 10.8 billion as at December and accounts closed in March after a provision of 3.5 billion. Its common equity tier one ratio was the third-worst after Banca Monte and Raiffeisen Bank International, but it was still 7 per cent.

The overarching lesson is that money should be ancillary to the economic system

Then in June 2017, less than three months later, Popular’s 10.8 billion of shareholders’ equity falls to zero. The efficacy and authority represented by local and EU regulators and inspectors is highly suspect if they cannot detect impending signs of a 100 per cent drop in shareholders’ equity.

The central bank’s role as the “lender of last resort” is not intended to promise a complete underwriting of all regulated credit institutions’ liquidity risks. In practice, this commitment can influence investors and counterparties to doubt the “going concern” principle and heighten solvency risk, especially if the central bank stops lending to the bank and its share price rapidly collapses.

It is perplexing and incorrect for the ECB to announce that it believed Popular was solvent but likely to fail due to liquidity issues. This is especially true when the primary role of a central bank is to ensure that a solvent bank does not experience liquidity issues. Without knowing it, the ECB has effectively implied that it has failed in its duty to provide liquidity to a solvent bank. Therefore, as a consequence the bank is likely to fail, so it must be resolved.

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Confusing liquidity versus solvency is a conceptual trap. Banks should always fail if they become insolvent. Solvent banks should never fail due to liquidity issues because central banks should provide liquidity.

Failing banks are unattractive investments in today’s market. The dilemma facing central banks is that as more deposit holders withdraw cash, more funds will be needed to shore up banks’ capital ratios. That reducing a bank’s liabilities requires capital injections to maintain capital ratios appears nonsensical. But that represents the unintended outcome and behaviour in the mayhem of a liquidity run.

The overarching lesson is that money should be ancillary to the economic system. Money should not be the economic system. Failing banks must be allowed to fold. We shall never be able to return to a sane financial marketplace unless this fundamental of capitalism is reinstated.

Peter Guy is a financial writer and former international banker