From independence, freedom and truth


Bad banks and worse banks (II)

Fernando del Pino Calvo Sotelo

June 8, 2012

In the early nineties, Finland, Norway and Sweden suffered a real estate bubble. When it burst, as all bubbles do, an acute banking crisis overwhelmed them and their financial systems nearly collapsed. In spite of this, just two years later the crisis was history and their economies were growing healthily, with a total net cost to the taxpayer below 3% of GDP. All of this explains why the way these countries solved their banking crises is considered to be a paradigm. I understand, probably with excessive simplicity due to the fact that I am not a politician, that it makes sense to face any crisis by seeking out and copying the best practices of those who have already passed through similar –even if by no means identical- hardships . Two years ago, the Bank for International Settlements published an outstanding paper explaining the principles applied by these countries and drawing conclusions full of common sense. I suggest that our authorities’ schedules add flights to Oslo, Helsinki and Stockholm in addition to their frequent flights to Brussels. I would also suggest they take pen and paper with them.

The first principle of the successful Nordic Way in dealing with banking crises is the following: “the nature and the size of the problems should be recognized early and intervention should follow quickly”. The goal is to prevent any inaction that would cause a sharp deterioration of confidence, the sole and extremely fragile base on which the fractional reserve system stands”. In such a system, clients cannot withdraw their deposits simultaneously and instantly. However, the forces of inertia do bias policy-making towards inaction. These forces aim to deny the illness to avoid surgery. Unsurprisingly, they put monetary authorities, bankers and politicians on the same side. Politicians do not want to acknowledge any crisis whatsoever (like Supertramp’s Crisis? What Crisis?); they are even less willing to assume the inevitable cost to the taxpayer (read voter) that the situation would demand. Monetary authorities (central bankers) do not want to recognize that, under their noses, a funny systemic crisis somehow slipped through. Oops. Finally, the incentives and egos of the management of commercial and investment banks, and the interests of their shareholders, hinder any action which might endanger their careers, image or wallets. The cynical trust in that the government will save them because they are “too big to fail” doesn’t help either.

The second principle, according to the Bank for International Settlements, states that “intervention and resolution should be broad-ranging and in-depth.” The goal here is to restore confidence and trust and also the system’s capacity to operate sustainably without public support. Three actions are needed: first, stabilizing the financial system maintaining liquidity and ensuring banks’ access to funding (central bank’s help being needed); second, restructuring balance sheets. This is essential to restore confidence. Losses must be exhaustively recognized applying extra doses of prudence. Finally, you need to re-establish the conditions for sustainable and profitable operations. To achieve this, it is indispensable that excess capacity, a usual byproduct of credit bubbles, be reduced.

The third and last principle applied by these Nordic countries is to “balance systemic costs and moral hazard”, an equilibrium between allowing an abrupt adjustments to be caused by the market pricing mechanism and tolerating impunity and perverse incentives to the sector agents, temporarily protected by authorities from the market healthy discipline. Who is to pay for the adjustment? Well, applying rigor, shareholders come first; subordinate debt holders, when possible, come next. Last, but not least, State aids should be conditional and temporary.

In Spain we have breached the first principle through denial; we have tried to breach the second with a slow banking “striptease” instead of getting naked immediately. Now a total clean-up of banks’ balance sheets seems imperative. This is the last chance to tell the truth, because we stand at the edge of the cliff. Pretending that the only toxic assets are those corresponding to developers seems illusory. The credit bubble reached all corners of the economy and, therefore, the volume of assets concerned is much, much larger (i.e. M&A financing at unrepeatable prices). Individualized analysis for each entity is required to the extent possible, but when in doubt the prudence principle should apply. This means recognizing losses and, in many instances, increasing capital and diluting existing shareholders. The priority should be to tap the market for new capital; subsidiarily, the State should step in. It just seems fair that, should the State provide financial support, it should also share the upside through either capital or warrants. We have to acknowledge the fact that Spanish politicians, whom it always pays to mistrust, get used to having a public bank at their service and then somehow forget about re-privatizing.  Luckily, the market’s pressure, due to our excessive debt burden, works in favor of the citizens, as it often does in other instances.

Real estate assets, once marked to market, may stay on the balance sheet of the bank or get sold to an independent entity. These bad banks have several advantages: assets are taken away from the banking sector, they do not flood a saturated market and banks can get bank to banking (if they actually remember what it’s like). Conversely, this option highlights the difficulty of finding a buyer and presents a conflict of interests between a seller interested in selling at the highest possible price to avoid embarrassment and capital dilution and, on the other hand, a buyer interested in real market prices that will allow him subsequently to unload these assets at a decent price. Lastly, those insolvent banks with foggy futures should be liquidated in an orderly fashion. The model of the cajas, the regional savings & loans, has proved to be an unmitigated disaster and a scandal, so far tainted by the usual impunity showed by our political caste. The cajas should disappear and those few institution with decent chances of survival should be transformed into banks.

Longer term, there are three lessons to be learned. One, we have to modify in depth the super fragile fractional reserve system, a permanent sword of Damocles; the ideal system of the future should reduce the leverage of the banks’ balance sheets and increase exponentially the cash reserve ratio, happily paying the price of slower credit growth. Two, the financial units should be easily ring-fenced in case any one of them gets into financial trouble. Three, we have to understand that the current Central Banking system with unlimited freedom of action and unchecked power poses huge dangers: the supposed wise men were not so wise after all, and failed miserably.

Truth is the only solid ground on which to stand when a problem has to be solved. Truth sometimes means pain but, at the same time, freedom and hope for the future. Our recovery can only be based on truth, assuming our responsibilities and mistakes as individuals and as Society. It takes courage, but it is the only way.


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