On the IMF’s warning of a European sovereign debt and bank meltdown

Last night, I posted a video of Robert Shapiro warning that the EU needed to address its banking crisis promptly and thoroughly. I agree 100%. I also mentioned a New York Times piece I wrote on Wednesday. I had anticipated my NY Times article would be out today. It is not and won’t be coming until next week. So I am going to do a partial quote here in conjunction with some other commentary.

The question was about whether Europe will double dip. I said yes. But I wrote, speaking of the banks:

For me, the most worrying signs, however, come from the European banking sector. Contagion from the sovereign debt crisis has infected Europe’s banks, which hold large amounts of sovereign debt. Economists at the International Monetary Fund have calculated that European banks need 200 billion euros in additional capital… And without this additional capital, many European banks are not receiving adequate funding… The situation is tantamount to a wholesale lending bank run.

This state of affairs cannot continue. One would not be overstating the case in drawing parallels to the fateful events in 1931 that spread from the Austrian bank Credit Anstalt to the rest of the European banking system and into the U.S., creating bank runs and depression… until the banks take substantially more credit writedowns and recapitalize, this crisis will continue and get worse. Europe needs to take action now.

The question is what kind of action. I have always been in favour of a Swedish Style solution, as I wrote in mid-2008 regarding the US. The point is to recap the banks before meltdown occurs. The Europeans have this chance. Kantoos Economics explains:

An insolvent bank could be recapitalized by injecting public equity, a procedure that is relatively straight-forward. But what if multiple sovereign defaults (say, GR, POR & IRE) cause banks to be really, well, doomed? In other words, if it costs, say, an equity injection in the order of 10% of national GDP to bring a bank back to solvency? You probably think that cannot happen, but it did! Not in Iceland, the costs there would have been even higher. In Ireland, it is projected to cost the taxpayer more than 20% of GDP to bring just two banks back to solvency, as Karl Whelan reports.

So what about burning bondholders in this case, not just shareholders? After all, they received interest for taking on a risk, however small. And now it is materializing. There is basically a trade-off here: the unfair, inequitable and, quite frankly, scandalous clobbering of taxpayers (to borrow a phrase from Willem Buiter) for the benefit of bondholders vs. the danger of knock-on effects – if these bonds belong to another bank that gets into trouble itself because of that, the taxpayer may have gained little by burning bondholders.

On the idea of stuffing bondholders in Ireland, Irish economist Karl Whelan says proceed with caution. First you need to wipe out equity. Then, if that doesn’t cover the loss, you move on to sub debt. But, then it gets tricky. When this approach was mooted in the US over two years ago, I wrote that “taking too much of a haircut on bondholders, especially senior bondholders, will undermine confidence in the system.” Even so, to the degree that senior debt and depositors are pari passu, you have to write down deposits at the same rate you right down senior debt. That’s a problem Whelan has a fix for.

For example, one approach to protecting depositors would be to apply haircuts to both deposits and senior bonds (thus respecting pari passu), use resolution powers to immediately transfer the written-down deposits to new institutions and then use public funds from deposit guarantee schemes to fully compensate depositors.

In a May 2011 policy piece for the European Parliament embedded below, Whelan even tacks on this:

If done swiftly, over a weekend for example, the depositors involved will barely notice the haircut that was applied

Here’s where I come out on this: there’s really every reason to crack on with a credible solution to Europe’s undercapitalised banking system. Delaying risks real Armageddon scenarios that no one is prepared for. In my view, the Whelan and Kantoos discussion demonstrates there are credible plans out there to make this happen immediately. All that is needed now is the political will.