euro debt crisisMatt Rego raises a quite interesting question in connection with ECB’s help to Barclay’s

http://www.valuewalk.com/2012/03/barclays-bcs-gets-aid-from-ecb/

I think that post merits a discussion.

The ECB facilities are a quite natural measure to prevent a credit squeeze of private businesses.

The thing is that when a bank is faced with rejection of funding by its normal creditors it generally has nothing to do with “psychology” or irrational behaviour. It is the very rational conviction of investors and other banks that they are not going to see their money again.

The notion of a “bankrun” evokes a picture of James Steward with rose petals and deafness on one ear. That was the case in the 1930’ies when angered pensioners wanted to withdraw their cash, today a bank run is more that the banks money transfers don’t clear due to lack of bank credit.
As such a bank run is easier avoided today as loans can be granted, that will make such payments clear.

The main issue is not the extension of credit by Central Banks – be they national, Federal or ECB.

The problem is what collateral the squeezed bank puts up!

Normally the collateral is premium securities such as sovereign bonds (which are a bit problematic after Greece) and a few other. Traditionally it was gold for nations.
The problem with squeezed banks is that they rare have these prime securities, as all their liquidity is tied up in dubious issues of toilet paper.

The Danish Central Bank, and presumably most other Central Banks, have introduced the concept of “good” loans for collateral. There are a few problems with this otherwise excellent concept:

  1. How many times has the same “good” loan been pawned?
  2. How do a Central Bank judge a loan to be good. The sceptic will not take a distressed banks word for the quality of the debtor – the banks distress is in itself an indicator of poor judgement.

 

  • The concept thus means a portfolio of vetted, well serviced loans that is ready as collateral. And that is quite a lot of practical work – especially as there is most likely a reservation on this, i.e. only 2/3 of the loan value is accepted.
  • But the advantage is that these loans cannot be called home when the bank is squeezed – which is the normal bank procedure.thus depriving the banks of one of their more effective weapons against society: If you don’t help us we will drown you with the blood from our cut throat.
  • The other factor is that it will open the banks books to authorities – at least to a limited extend.
  • Finally it will provide a basis for lifting out non-lost credits and sell them on to other banks when the distressed bank either goes into some sort of receivership or is being split into a “good bank”/”bad bank” with a view to reconstruct.

 

Thus Central Bank extension of emergency credit has a perspective. The perspective of lifting out good loans so the impaired and defaulting loans are left in the rotten bank.

This means that new equity will not necessarily be dropped into a bottomless hole in a sick bank.

In fact transferring the good loans to a reasonably sound bank (hopefully with a depositor surplus) will be a much better background for raising fresh capital. Investors are rightfully sceptical about paying for already suffered non-booked losses on the basis of annual reports audited by fairytale auditors.

This could actually restore some confidence in a nations banking system.

My disagreement with having the ECB doing that sort of emergency rescue work is that they haven’t a clue (and can’t have) as to the quality of the collateral put up by the squeezed bank thus running a far bigger risk of taking losses.

Danske Bank is already exploiting the ECB’s lack of insight and hock the “securities” that the National Central Bank has rejected as actually pawning the same property twice.