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(This item originally appeared on Forbes.com on July 22, 2012.)
http://www.forbes.com/sites/nathanlewis/2012/...-holiday/
Anecdotal reports suggest that the various attempts to shore up banks’
condition with phony financials and vast theft of public money are coming to
an end. Despite these stopgaps, banks are still struggling, in many cases
taking steps to delay or prevent withdrawal of funds. This amounts to a sort
of soft default, which may progress soon to a hard default.
“It is increasingly likely that some kind of total target="_blank"‘bank
holiday’ is enforced to put a stop to market pressures,” wrote Saxo Bank
economist Steen Jakobsen in November 2011. He expected this to target="_blank" happen
in 2012.
Jakobsen notes that the United States did exactly this in 1933. It was quite
successful, and vastly improved the confidence in the financial system. This
helped the economy to recover during Roosevelt’s presidency.
It seems that many people don’t understand target="_blank" how banks
work, so we will start with a simplified example. The simplest sort of
bank has a balance sheet that looks something like this:
Assets: $1.0 million of loans (mortgage loans, credit card loans, corporate
loans, etc.)
Liabilities: $900,000 of borrowings (bank deposits, CDs, bonds, etc.)
Capital: $100,000
The bank borrows money at a low interest rate, and then lends the money it
borrowed at a higher interest rate.
However, sometimes the bank makes loans to entities that are not able to pay
them back. This is recorded as a decline in asset value. Borrowers won’t pay
back the $1.0 million they borrowed, they will only pay back $700,000.
However, the bank still has to pay back the $900,000 it borrowed.
Assets: $700,000
Liabilities: $900,000
Capital: -$200,000
The bank is now insolvent. The bank typically borrows on short maturity. The
borrowers can get their money back on short notice. The bank has to pay the
borrowers, but it has no way of doing so. Nobody will lend the bank money,
because its assets are insufficient. The bank thus defaults on its debts, and
is bankrupt.
At this point, what is supposed to happen is this: the bank’s liabilities are
restructured, so that lenders become equity shareholders. This is a
“debt/equity swap.” Afterwards, it looks like this:
Assets: $700,000
Liabilities: $600,000
Capital: $100,000
The old equity holders get zero, and the former bondholders become the new
equity holders. The bank is solvent again, its liabilities less than its
assets. No public money is required.
The people who loaned the bank $900,000 would find that the principal value
of their loans was reduced to $600,000. However, they would also become the
new owners of the bank. In this case, the bank has $100,000 of capital (book
value), so the market value of the equity of the now-healthy bank would
likely be at least $100,000. Thus, the lenders would end up with $600,000 of
loans to the bank, and equity worth at least $100,000, for a total of
$700,000. That is a loss from the original $900,000, but not a particularly
disastrous one.
In practice, demand deposits are typically treated as senior to bondholders
and time deposits. The result would be that depositors would be fully repaid,
and bondholders would have a larger portion of their principal value
converted to equity. For example:
Liabilities (before): $500,000 of demand deposits, $400,000 of bonds and
other borrowings.
Liabilities (after): $500,000 of demand deposits, $100,000 of bonds and other
borrowings.
This is what people mean when they say: “bondholders need to take a haircut.”
The bondholders would end up with $100,000 of bonds and also the equity of
the bank, worth at least $100,000.
This process in fact happens quite regularly. In the U.S., the FDIC has been
putting two or three small banks a week through this sort of balance sheet
restructuring.
However, governments have been hesitant to do so for large banks. If a large
bank was restructured, the entities that loaned the bank money wouldn’t get
all their money back. They would get some of it back, but some would be
converted to equity. The process would also take a little while. Since banks
often lend money to each other, and many large banks today are also
fundamentally insolvent, the result would likely be a sort of chain reaction:
if one large bank was unable to pay its debts, people would assume
(correctly) that other banks will soon be in the same position. Much of the
financial system would be in crisis simultaneously, leading to potential
chaos.
Thus the “bank holiday.” With government supervision, all banks’ operations
are suspended for a short period of time. In 1933, it was for eight days.
During that time, any banks that needed to have their balance sheets
restructured could begin the process. Healthy banks were allowed to reopen,
the public reassured that their bank was not insolvent. After the systemwide
balance sheet restructuring, all banks would be “healthy,” that is, with
liabilities safely below the value of their assets. They would no longer have
to lie about their financial condition.
Governments have been reluctant to take this step. It would require vision,
understanding, and also a bit of daring to pull the trigger. However, the
other options – thievery of public money, and printing money at the ECB – are
far more destructive, and have effectively reached their limit. It is no
longer so easy to steal public money, for the simple reason that governments
themselves are becoming unable to borrow. (There is never any need for a
“bank bailout,” although bankers want you to believe otherwise.)
With thievery of public money reaching its end stage, the last option is
aggressive printing of money by the ECB. This could have potentially
disastrous consequences, far worse than a few weeks of uncertainty as large
banks’ balance sheets are restructured.
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