Is there a better way to deal with bankrupt banks?

We all know about the financial crises across Europe. But an even bigger problem could be the state of Europe’s banks.

The big headline-grabbing worry just now is, of course, Spain, where a real estate bust is causing many mortgages to go bad. It’s little wonder that credit ratings agency Standard & Poor’s has just cut the ratings of 11 Spanish banks.

But this is not just about Spain, it’s a eurozone-wide problem. Thanks to loads of cheap money from the European Central Bank (ECB) and the meddling of politicians, banks across the European Union have taken on a lot of dodgy government debt.

What can be done about this?

Solutions from ‘bad-banks’ to ‘bail-ins’ have been talked about. But when push comes to shove, it looks like governments will end up bailing their banks out. It doesn’t matter whether this comes through guarantees, capital injections or asset purchases. Yet again, it will be the taxpayer who will end up footing the bill.

But is this really the right thing to do? Here are three alternatives to taxpayers having to pay up.

1. Let them go bust

Why not let the banks go under? In this case, they would be treated like any other business that made bad (or unlucky) decisions. It would also be a powerful warning to other banks that were tempted to make lazy decisions or to take on too much risk – in other words, it solves the ‘moral hazard’ problem. This sink-or-swim approach would mean that there was no direct burden on the taxpayer.

However, there are several problems with this approach. Firstly, it would take time to sort out competing claims. This would create a huge amount of uncertainty. Indeed, savers may be unable to get at their money while firms may be left without access to essential funding such as overdrafts.

Letting the banks go bust would also lead to a forced selling of assets. This will push down the prices of bonds, reducing the amount that bondholders get back ,and will hit other holders of similar assets.

Asset firesales, and the absence of any state support could also lead investors to panic about the solvency of other banks. That would lead to contagion and the threat of a run on the wider financial system.

2. Bail-ins: an intriguing alternative

A less disruptive solution that still places less of a burden on taxpayers is the idea of a “bail-in”. As with the first option, shareholders would be wiped out, while bondholders would also take losses (depending on their seniority – ie, which order they come in the creditor queue). So as with option one, you largely avoid the moral hazard problem.

However, in this case there would be no need for the firm to be wound up. Instead debt would instantly convert into equity. In essence, this is an accelerated version of the bankruptcy process.

The main benefit is that this would reduce the amount of disruption. The solution could work as long as the reduction in the value of a bank’s assets could be absorbed by a combination of its equity and debt. If the write-offs are bigger than this, then there could still be lots of problems.

If not, then this could be good for savers and others who rely on the bank for everyday transactions. The ‘bailed-in’ bank would be able to sell the ‘toxic assets’ at a pace that allowed it to maximize revenue, or even hold them to maturity. In turn this could also prevent the market from becoming too depressed.

However with this process you need to have a regulator or central bank, instead of the courts, attempting to rank claims. This could lead to mistakes. To avoid legal battles, the bank’s creditors would either have to agree, or there would have to be laws already in place.

3. ‘Good’ and ‘bad’ banks

Another idea is to set up a ‘bad bank’.  This bank would buy toxic assets from banks at a price that kept them in business.

The idea here is that banks could then get on with their core business without having to worry about selling assets or going bust. While this process does involve bailing out the banks, taxpayer support could be minimized by either recouping any losses via a bank levy – a specific tax on banks – or by forcing the banks to contribute capital to the fund that buys the toxic assets.

Supporters of this method argue that it minimizes disruption while reducing the overall cost to taxpayers. They also point out that prior to the 1929 Wall Street Crash, large US banks were expected to bail out smaller institutions when the latter got into trouble.

However, critics point out that forcing solvent banks to support insolvent ones allows the latter to ‘free-ride’ on the prudence of the former. It also creates a form of moral hazard, where the promise of rescue means that less prudent banks continue with their reckless behavior in the future.

And unfortunately, it also doesn’t work if the entire industry is insolvent (as is likely to be the case in Spain). If this is the case, taxpayers are the ones who end up funding the ‘bad bank’ and shoulder the risk of losses.

What we would do

All three solutions are arguably better than straight bailouts, though the third option still involves some moral hazard. The experience of Iceland proves that the first option can work, with the state only compensating depositors.

We’re not saying it would be easy, and Iceland was arguably driven to do it because it had no other option, but with some planning it should be possible to create a regime that would allow banks to go bust in the future without fears that civil society will collapse.

Sadly, this would also require government, regulators and central banks to resist special pleading. This looks unlikely. For example, the Dodd-Frank reforms passed two years ago require the Federal Reserve to consider a range of options. However, a simulation of the crisis, involving former Treasury Secretary Larry Summers resulted in him suggesting that another state bail-out might be needed (even though the legislation was intended to make this difficult).

So for all its tough talk, Madrid is likely to go down the Irish path, with support for failed banks essentially bankrupting the country.

  • Peter Kellow

    I didn’t really understand how the “bail in” works

    I disagree with letting the banks of the hooks with this:

    “Thanks to loads of cheap money from the European Central Bank (ECB) and the meddling of politicians, banks across the European Union have taken on a lot of dodgy government debt.”

    Why cannot we ever allow that banks are businesses that make their own decisions. They did not have to buy the debt. The truth is they did so knowing that they would be bailed out when, not if, the debts went bad.

    Of course, you might say that that was a sound business decision.

    The fourth alternative that was not mentioned is to deprive banks of the right to create credit and return this facility to sovereign states where it belongs

    This is the only democratic solution and in the end that is the only way that western economies can survive

  • Jules

    I had a look at the Economist article about bail-ins (http://www.economist.com/node/15392186) and I have to say it looks like an intriguing idea. One of the points made there is that, while a bail-in is a firefighting measure (“To preserve value, officials would have to move very, very quickly, leaving little time to fine-tune various claims…”). You express the concern that “This could lead to mistakes. To avoid legal battles, the bank’s creditors would either have to agree, or there would have to be laws already in place.”

    I’m not so sure. If the alternative is to wait, and go through a proper bankruptcy process, the bankruptcy itself will destroy whatever value remains. The goal is not necessarily a strictly equitable distribution of what value remains, but “ensuring that each class of investors would be better off than in liquidation”. That being so, all that would be needed would be some statutory or regulatory greasing of the wheels.

  • Jules

    Peter: there’s an obvious problem with letting insolvent banks collapse – they take the rest of the economy with them!

    It’s fine to talk about “Moral hazard”, but the truth is that a bank is not like a corner shop: the moral hazard of a bank is borne disproportionately not by the shareholders and directors, but by depositors (who should not be taking on hazard at all just by being a customer.)

    Unless you’re advocating nationalising all banking, then what applies to a small business changes when you scale it up to the size of a multinational bank. You don’t necessarily need to protect the bank, but you do need to protect the economy it’s part of, and putting the bank on artificial life-support may be the easiest and quickest way to do that.

  • Aduffawol

    How about this Matthew , allow the central bank to print money and lend it out at 0 percent. The banks then use this dirt cheap money and lend it out at higher rate. The result is that the bank can offset losses made in the past with profits made in the future and also gives time for assets to recover in value ultimately allowing the banks to pull themselves out of insolvency.

  • Jon

    Whatever the solution to resolve a bankrupt bank, i have not heard any sound of formally introducing an ongoing charge to the banks for the implicit and explicit (UK’s £85k depositors) guarantees provided by the state.

    Surely it would not be too difficult to put a risk premium on this and charge the banks accordingly.

  • Clarinetplayer

    Aduffawol: Isn’t. this what we currently have (more or less)? That is, monetary authorities have purposely depressed the cost of money, thereby allowing banks to fund themselves cheaply and slowly rebuild their balance sheets through retained earnings? The problem is that such “accommodative” monetary policy distorts financial markets and penalizes savers or those who need to rely on safe investment income (like annuitants).

  • Boris MacDonut

    Money is created by QE. The banks borrow it at Libor (1.02%). They lend it back out at 4 to 10 %. This literally is a license to print money. The easy money they now make is set off against the losses still coming home to roost from the days of largesse.
    The so say profit they make is then used to justify exorbitant pay for the senior staff and absolutely NO effort is made to repay the taxpayer. A limit of £150,000pa for ALL staff shouild be the prerequisite for our bailout. Failing that Bob Diamond should walk the plank.

  • Aduffawol

    Clarinetplayer yes your right we do have that situation but I’m saying it should be brought further and interest rates should be brought to 0. This basically transfers the debt from the banks to the central banks who can take such losses as they are the money printers. This swells the banks balance sheets with liquidity which will be paid back at 0 percent so the central banks will get back less that what they give considering inflation.The point is that this debt must be taken out of the financial system and replace with liquidity and the best institutions to do this are the one that make the system. Now on your point relating to savers, yes inflation will erode people’s savings but not necessarliy as I am sure Yous have notices when central banks conduct monetary printing there is a rise in asset and equities as people rush to be protected. So the suffers will be the ones that will only save cash!!

  • Aduffawol

    Another possibility is to introduce temporary interest rate floor on savings. Banks would be making enough money form the cheap rates to do this and in turn the only main suffers would be the borrowers. Now I know this would be very complex to implement and contracts the cheapskate BoI rate theory but thats the times we are in.

  • Peter Kellow

    What the article and the comments show is that the system we have now just does not work

    It has nothing to do with the market economy. It is either a reinvented feudalism

    We cannot go on like this. You cannot turn a population and an economy into debt slaves of a single monster rentier sector and imagine that it can endure

  • Aff

    Option 1 gets my vote. Iceland has shown the way

  • Lupulco

    My vote is with Aff, but we should have done it in 2008, but it is to late now, we are all doomed.
    But i do agree with Boris MacDonut
    If we st a limit on earnings and a freeze on bonus payments till these problems are fixed.
    I know the CEO’s say “we will leave”, but
    a] where to, b] what will their wives/partners say? and c] there are lots of young people in the back ground who should be given a chance.
    Lets call their [CEO’s] bluff and see what happens/