A litmus test for the theory that Europe, in the end, ‘gets it right on the night’: Will it allow the EFSF to recapitalise banks directly?

A currency union requires a unified banking sector. With one supervisory authority that keeps banks in check (and, hopefully, in awe), re-capitalises them when the need arises and, when this happens, takes a stake in them in exchange for the capital injected into the banks.

It was an act of gross omission on behalf of the eurozone’s ‘founding fathers’ to allow national banking sector supervision to co-exist with the new common currency. And it is an act of scandalous commission to maintain now, in the face of our acute euro crisis, that things must remain as they are.

Suppose that, in the Fall of 2008, the various states comprising the US had to refloat and recapitalize, through state borrowing, the banks whose seat was located on their territory. The result would be that both the states and the banks would have sunk without a trace in the quicksand of bankruptcy. Ireland and Spain provide an excellent case-in-study on the other side of the Atlantic. And they confirm that the euro-system’s founders were bordering on the criminally negligent.

Euro-optimists tell me that “it will be alright on the night”. That this is how Europe evolves: A bad design is put in place, a crisis occurs, Europe responds haphazardly and equivocally but, eventually, it “does the right thing” by itself and by its survivalist interests. My concern is that the fact that it has done so so far does not guarantee that it will “do the right thing” this time around. But I am prepared to keep an open mind. However, the manner I which it deals with bank recapitalisations now, and whether it will push for the direct recapitalisation of banks by the EFSF, will be a decisive litmus test.

Our Modest Proposal has been steadfast in its insistence that such a transformation of the EFSF (and consequently of the eurozone’s banking sector) is sine qua non: that the EFSF should be transformed into a body that re-capitalises directly Europe’s banks.[1] This would mean that capital (which the EFSF borrows from the money markets, effectively, on behalf of triple-A countries) is injected directly into the banks; that the EFSF receives common stock in return; that, once such recapitalisation is complete, these shares are auctioned off to the highest bidders (thus repaying the taxpayers who put up the guarantees on the back of which the EFSF borrowed).

Last week Adair Turner, Head of Britain’s Financial Services Authority (FSA), suggested exactly the same solution to the Eurozone banking crisis: That “…the European Financial Stability Facility and the European Stability Mechanism [ought] to funnel cash directly to struggling lenders [so as to] help solve the region’s debt crisis and be a ‘limited but vital’ step on the road to greater fiscal integration among the 17 nations that use the euro.”[2]

Wolfgang Munchau seems to agree with both us and Adair. In a recent FT article, entitled ‘The sadly unpalatable solution for the eurozone’, he sums up this proposal thus: “The idea is essentially to take the nation state out of banking and to make the eurozone – or the European Union – responsible for everything. The notion of, say, a Spanish bank would cease to exist.” However, quite correctly, Munchau points out the reasons why this common sense approach has not been adopted, and why it is meeting with incredible resistance amongst politicians: “It is hard to conceive of Germany’s corporate sector without its cosy relations with the banks”, he points out. And of Greece, of Spain, of Italy etc., I would add, as I have been arguing in this blog repeatedly over the past two years.

As if on cue, eurocrats came out (after our recommendation was floated in Berlin, at the INET Conference) to pour cold water on the idea. Here is a Reuters title that captures their reaction succinctly: “Direct bank recapitalisation by euro zone funds unlikely, say officials”. Indeed, Klaus Regling, the EFSF’s chief (admittedly not the sharpest knife in the eurocracy’s drawer) had this to say: “ “If I were asked to give money directly to banks I would have to manage banks… We are just not set up for that.” Well, be that as it may Mr Regling, perhaps it is time to become ‘set up for that’! For the alternative, is (to use Munchau’s expression) uttetly unpalatable: Having the Greek, Spanish and Irish governments pile even more debt on their puny shoulders on behalf of ‘national’ banks, is to fly in the face of basic architectural principles. It is akin to leaning a super-heavy scaffold against a collapsing building in a manner that guarantees the collapse of both the scaffold and the building.

So, here is the crux, the ultimate litmus test, for euro-optimists who think that this Crisis will force our leaders/officials out of their torpor, and into action: Will Europe allow the EFSF directly to recapitalise the banks, transforming itself into a proper Eurozone banking authority in the process? If not, all talk of a Europe that eventually ‘does the right thing’ will be proven to be little more than hot air.

[1] This policy proposal first appeared in Version 2.0 of the Modest Proposal (March 2011) and has been an integral part of all subsequent versions – e.g. here and here.

[2] Victor Mallet, reporting from Madrid for the FT, also suggested something similar: a form of a ‘bad bank’ for Spain’s crippled banks (and the mortgages that have blown up in their faces) to be financed directly by the EFSF. “The EFSF can do it and that’s not a bad idea… The point is, they have to avoid a whole troika programme where Spain’s access to markets gets frozen and all financing is provided by official lenders.”



    • cig: “making shareholders/bondholders pay doesn’t fundamentally change the problem”….such a view is typical for the years of smokescreen approach with invented digital money and what is more it seems to me that you too are not very sympathetic to the idea of the actors assuming responsibility at their respective level of involvement – a major flaw in the management of our casino capitalism. If governments eventually have to come to the rescue of failed bank, these govts MUST condition their support on reciprocity of sacrifices. At the end of the day share capital and unsecured bondholders will anyway lose their moneys – perhaps an invitation to them to support much tougher controls and regulation for the industry as a whole and in support for all those that have invested in banks (e.g. UBS bondholders are very large stakeholders – a point that you seem to ignore). Paul F.

    • Paul, the problem is that a lot of actors are genuinely innocent. Ordinary people, like teachers, firemen, steel workers, who know nothing about finance, own banks, via pension funds, the backing funds of insurance policies, and more intricate forms of entanglement. Most of them do not know they own banks, but they do. The finance guys made their money from charging fees to help ordinary people own banks, not (only) via owning banks themselves. Some financiers may own banks as well on their own account, but not enough to save the system even if you somehow managed to recover it all selectively.

      Many of these people who own banks but are not aware of it would agree with you to make shareholders pay. And if it was done, they’d get the bill.

  • Considering the individual responsability of each bank for its own business decisions and practice should it not be in the very first place the shareholder and to the extent possible the bondholder who should bail out that specific bank that is running into troubles? Yanis, what about the subsidiaries, e.g. in Montevideo of these same Spanish banks, they would happily continue with moneys that come from European tax payers? And really the moneys available in these digital money screens called bail-out funds would they go anywhere considering total bank balance sheets in the 25 Eurozone countries of incredible Euro 46 trillions? Question: do you really think these banks would make whole on those funds they get from any of those smoke-screen institutions to which Spain is committed to pay also dozens of billions of Euro. Isn’t it totally ridiculous: the garantor receives its own guaranteed funds and counting? And where should that money come from in the current Spanish Republic? Vive les Ponzi-Scheme! Have you really thought it through?

    Paul, Montevideo

    • Paul, the conundrum of Europes’ big banks, which you describe as “les Ponzi-Scheme” is actually an ongoing criminal enterprise that has been legalized over the course of the last 15 years or so. My preferred answer of what to do with them is from Martin Wolfe of the FinancialTimes – turn them into utilities, if necessary nationalize them to make them utilities, so they serve in traditional banking role.Then let the speculators form their own investment companies, get them out of banking.

    • “Then let the speculators form their own investment companies, get them out of banking.”
      Spot on !
      We need a Glass-Steagal act YESTERDAY !

    • Making shareholders/bondholders pay doesn’t fundamentally change the problem. The ultimate stakeholder of banks, is essentially, via a big spaggeti bowl, the taxpayer (aka you). There’s no big nasty capitalist with a top hat and a pipe who owns banks and whose paper wealth we could just cancel, and it’s not because we can’t cancel paper wealth, it’s because the guy doesn’t exist (at a material enough level). So resolution has to come through a form of (inter)nationalisation.

      @Crossover, the EU bail-in plans, if they end up in the right place as looks likely (with auto-split on insolvency) in time, will likely produce the same result as a Glass-Steagal would (as everybody auto-splits during the unfolding).

  • l agree the EFSF ought to be able to recapitalize eurobanks directly without intermediaries.

    Take for example the Greek banks. After the horrendous PSI which left banks breathless (Greek banks have already lost about 99% of their market value and are in urgent need to bounce back in some form of credible existence other than zombie status), the first agreed upon trance aimed at their immediate recapitalization is sitting somewhere in a Greek state account subject to troika’s and politicos’ approval.

    Greek banks at present can’t even perform the regular functions of banking and are unable to provide liquidity into a moribund economy. Normal people might think that recapitalizing the banking sector must be done ASAP. Greek politicians now are saying that it may take until December (meaning after the meaningless election of May 6th and the subsequent election of circa six months later). To put it in plain language, the lenders are not willing to recapitalize the Greek banks until they have iron clad assurances of a stable government of their choice. Which is another notorious breach of all democratic principals known to every man, woman and child.

    Check this out: The EU is saying that Greece is not allowed to have any banks in reasonable shape until and unless Europe approves of the next Greek government whose final form is not expected to emerge any sooner than year’s end.

    Nice, real nice. In plain language: “Eff off Greek people; we will decide what form of government you will finally get because he who has the gold makes the rules”. As I said: Nice, real nice. And as you can expect the warm feelings towards the Germans are rising by the day.

  • “had to refloat and recapitalize, through state borrowing, the banks..”
    Why, I say, WHY. You economists, (of which you are one of the few who seem to have a clue) think INCREASING money, credit, debt is always the solution. So, how many time has that worked for the ordinary people eh. Banks have inflated the amount of euro’s, debt and asset prices in absurd proportions. What is wrong with bankruptcy. “Bad for the economy”, I’m sorry (not) but it was what happened before what was bad. But economists don’t care, they think the rich are the ones with money. No they’re not, they profit from more bailouts, more money, more debt, more inflation. They own the debt ,the assets, they are first in line of the money FLOW. Please get away from the religious dogma’s.
    States, nations can nationalise banks without the debt, apparently that is taboo.

  • I don’t get it. Who is saying that bank recapitalizations should not be done directly by the EFSF? (a question mark because I really don’t know). I can’t imagine that the EFSF is saying that? I mean, who would want to recapitalize a bank without having a direct say in it? On the contrary, it is standard operating procedure to have a direct say!

    When I read that the recapitalization of Greek banks would be handled via the Hellenic Financial Stability Fund, I thought that this was an unfortunate political compromise: so as to be able to say to voters that no foreigners would get ownership in Greek banks. A bad compromise because to lend money to someone who turns around and converts borrowed money into equity is not a very prudent structure.

    Rehn says the EFSF doesn’t have enough management resources? Doesn’t need to have. All the ESFS needs to have is enough supervisory resources (and if they don’t have them, they can hire them).

    • Dear Klaus, you ask: Who is saying that bank recapitalizations should not be done directly by the EFSF? The answer is the very charter of the EFSF, Europe’s leadership and the EFSF’s Mr Regling. The EFSF was set up in order to borrow on behalf of governments. By its charter it can only lend to governments. So, when it was stipulated that the EFSF will be financing bank rcapitalisations, it was made clear that the funds will go to the banks via governments that will (a) choose how to dispense them among their ‘national’ banks and (b) take on their (puny) shoulders the new debt (thus ensuring that the recapitalisations add to national debt!). It is pure madness. As you correctly say it would be no big deal for the EFSF to give the money directly and even to subcontract banking supervision (e.g. to the European Banking Authority). But they refuse to do it. Why? Because our politicians WANT to maintain their cosy relationship with the ‘national’ banks. And so Europe is entering deeper and deeper into its special black hole.

    • Thanks for the info. I would have thought a charter would be amended if it turns out to become necessary and prudent. Not very smart business practice to put up money for recapitalization but be removed one level from the object of it, regardless whether it is private or public equity!

  • Why do economists not tell us that the current situation of Euro and Europe is the best thing for US?
    To start with we have the FED printing outrageous amounts of dollars (when the dollar was priced much lower than the Euro). This is of course a bad thing since all this “cheap” money had no real value behind it. However this situation could be rectified if the Euro would collapse (with the help of Germany) such that with 1 Dollar one could buy ~2 Euros or more. The extra money that was printed by the FED, would now be gold in the hands of its owners which could make a party over the bankrupt nations of Europe. Surely the helping country (Germany) will jump off the Euro-train much earlier than Euro’s collapse returning to its Mark (and thus to safety) after paying back the US for the help it received post-WW2.
    Yannis, do you agree? Or do you think this is too much of a simplification?

  • All the zombie banks should be dismantled right now, not recapitalised with even more taxpayer’s money.

    • Exactly. And no European institution helped to fund the German Landesbanken and others in 2008. So why should Germany fund Spanish banks. We don´t give a damn about the ClubMed problems.

    • “And no European institution helped to fund the German Landesbanken and others in 2008”

      Did they? If they did, it was of course wrong. The Landesbanken, like any ZombieBank elsewhere, should never have been brought into tax payer funded existence.

      But post facto, and then as things went horrible, they should have been dismantled immediately. Like any other bank should… Oh. To many subjunctives.

    • Fully agree. The government is not the better entrepreneur or banker. The favorite clients of my friend who sells structured financial products were alsways the Landesbanken…