I owe the long suffering readers (both of them) an excuse for using Denmark as a model for the technicalities of the European bank crisis. I had no intention of implying that the entire world was to genuflect in admiration of some provincial hicks stunning example. In fact it is the other way round:
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The EU has a general model or plan as to how to get to grips with the financial sector. In my estimate the reason for Denmark in some cases being ahead of the main developments is due to the fact, that Denmark is not a member of the Euro-zone. It is a wise mouse that gets out of the way when elephants are fighting – and in that process benefits from the trembling of the earth.
The general reaction to the collapse of Lehman Brothers in 2008 caught both the US and the EU by surprise – a surprise that even at the time was pathetic. It wasn’t like there had not been warnings: House price developments, debt problems and so on were well known and widely ignored. The crisis came for the US at a particularly inconvenient moment (who has ever heard of a convenient crisis?) – In the transference faze of power between president and president elect. Europe had no such excuse.
This general panic resulted in inappropriate measures taken, in all essential dictated by the banks – the very banks that came crying after having made an incredible dogs dinner of things. We could mention sovereign guaranties without limit or discretion relying on information from the banks.
In the aftermath the general procedure seems to be:
Introduce standards as to the quality of the bank’s assets:
1) Objective signs of weakness: This ranges from checking that the debtor is still alive or wanted internationally by the police – over finding out if the debtor is servicing loans – over signs of distress (lapsed payments, reduction of inters, etc.) – to evaluating if the debtor stand a chance of ever being able to pay his way. These measures are only effective in the more extreme cases, as banks assurances and evaluations are little better than boldfaced lies.
Before becoming too upset with the lack of business morale – any realistic person will admit that in the situation he would do exactly the same.
2) Introducing objective standards to establish the value of the collateral. That may be property value where market price is not a very good standard as denying credit will force sales so far down that the market ceases to exist. This only works if the bank has a serious deficit of deposits.
Limit guaranties to some depositor – let the depositors lose money. Banks normally guarantee depositors from losing money; but at some point the banks that have to foot that bill gets tired of cleaning up after others.
The result will be that banks stop lending their excess liquidity to each other and place it in either sovereign bonds or CB deposits. This has two consequences for the CB:
a) To avoid unplanned (or rather uncontrolled) collapses it means that the CB will have to provide the credit to the banks short of cash. This isn’t to serious as such emergency funding will be against prime security – typically sovereign bonds.
b) As banks in distress rarely have too much prime collateral there will have to be a relaxation of criteria – f.i. acceptance of “good” loans as collateral. The point is however that it gives the Central Bank an insight into a bank’s books – which is something a bank loathes. As banks run short of cash it might be caused by their loans not being serviced, so the CB is liable to catch the problematic banks in order of severity.
The next trick is to take over the bad loans that threaten the liquidity of the bank, but instead of taken the banks assessment and just suffer being a dustbin, these loans should be:
a) Impaired according to an objective resale value standard of the collateral. And the impairments should follow the loan.
b) Guaranteed by the bank to the extent that further deterioration will be at the cost of the bank getting the liquidity.
c) The loans supported should stay on the banks books – or the reports are liable to “forget”. Probably the best way to do it is that the bank in distress makes an internal “bad bank” as a wholly owned subsidiary.
d) The Spanish case show us a new twist to these rules: 5% of these loans shall be sold off annually. This prevents making it a Japanese icebox – and forestalls panic sales.
This way out is one that only a severely distressed bank will use and only under severe duress a lot of tricks and political pressure will be used to avoid this very intimate scrutiny.
The arrangement does afford an insight into the real state of solvency of the bank – they will have to take the necessary impairments. But yes, it is the near terminal situation just before being taken over by the authorities.
Another advantage is the ability for the public to consolidate bank loans on a client/company basis which may ease the workload in a bankruptcy of the client – which otherwise take years.
A smart trick to get a feeling for the situation of a bank is to demand that payments between banks should be paid in full to the central bank on a monthly basis. Normally transfers are adjusted on a net basis.
Indubitably the EU has come a long way since 2008. There is a far larger toolbox – and it is being used. We saw it in Denmark back in 2010 when life insurance companies got prescribed mortality tables to calculate their liabilities and as a residual to find out the true size of their reserves – some savers got a the very nasty surprise that their pension fund could not keep what they had promised.
In November 2011 we saw the Danish Central Bank relax their standard for collateral. Same year we saw a compulsory standard acreage value for farms and the enforcement of independent valuation of rental property.
It is very clear that EU standards are being enforced with tools applicable to varying degree considering the qualitative and quantitative differences of the different nations and banks. We saw Rajoy in Spain deny an old party comrade assistance deviating from the EU standard.
The next ECB challenge will be to avoid phony recapitalization of the banks through crossholding: I.e. Bank A sells 1 bio. Euros in its shares to Bank B that sells Bank A a similar billion of Bank B shares. On paper the equity has been restored in both banks, but in reality not a penny more has entered to support the sectors consolidated balance sheet.
Another problem is the number of own shares that lie as collateral for loans issued. In the event of calling home the loan these shares will enter the banks stock of own shares – thus indirectly boosting the exchange quoted value – a value these shares cannot be sold to on the stock exchange.
The other original perspective for the ECB is – in case of national inability to provide either temporary liquidity or permanent recapitalization – that the ECB in some sense enter as the CB’s CB. According to Jörg Asmussen of the ECB in Handelsblatt we are not there – yet.