I think that regular readers can predict my answer. It is the one that in fact any banker would, in a fit of honesty, give you: Non-performing loans must be deleted from the banks’ books. Same with derivatives that stand no chance of finding a market/buyer. These nonperforming paper assets weigh banks down and ensure that any liquidity that comes their way (either from the ECB or from the state or even from the private sector) will be hoarded. The very definition of zombie banks (which were first encountered in Japan in the 1990s).
Now, the problem is that, if you forcebanks to come clean and write down these non-performing paper assets (which is what US Treasury Secretary Tim Geithner forced banks to do with the proper stress tests conducted on the other side of the Atlantic), our banks will all appear insolvent (because they are!). Unable to raise enough capital to avert formal insolvency, they will have to be saved by the tax payer. Then again, the Greek taxpayer lacks two pennies to rub together to recapitalise Greek banks. The same applies to the Irish. Protuguese and Spanish taxpayers. Even the German taxpayers would be hardpressed to come up with the cash, espexially when such a move would not help much at a European level (if, meanwhile, the banking crisis continues to unfold beyond Germany’s borders). So, what do we do?
This is where the EFSF has a legitimate role to play – the only one, in my estimation, since loaning governments, as it currently does, is utterly problematic and turns the EFSF’s operations into a CDO like structure: The banks that cannot raise funds to recapitalise after a write down of their nonperforming paper assets should be forced to exchange equity with EFSF funds. The EFSF can hold on to these shares until the banks recover (as per the Swedish 1990s case) and then sell them, thus recouping its own costs (perhaps with a profit). (This is indeed an integral part of our Modest Proposal 2.0)
The only ‘loser’ here is the current owner(s) whose ownership will be deluded. Alas, the price an entrepreneur pays for bankruptcy is either closure or (partial) expropriation. I think that the name for this game once used to be well known: Capitalism (or Creative Destruction if you want to be a little more Viennese). In the era of Bankruptocracy, even simple capitalist principles are denounced as… left-wing.