More public money required for bankers as IMF warns of €200bn blackhole in European banking system

Most International Monetary Fund reports are necessarily the result of compromise and negotiation. Rarely is the IMF allowed by its nation shareholders to tell it exactly as it sees it.

So the warning in the IMF's latest "Global Financial Stability Report" that European Union banks face a possible capital shortfall of €200bn to €300bn as a result of the eurozone sovereign debt crisis comes as quite an eye opener.

European governments will have fought this assessment tooth and nail, for not only does it seem to add fuel to what is already a raging panic around the solvency of the European banking system, it also provides some indication of quite how much more public money is going to be required for recapitalisation.

The IMF is at pains to stress that the big numbers cited are an estimate of the increased sovereign credit risk in the EU banking system over the past two years, not of the extra capital needed by banks as such. None the less, they do provide a reasonable guess at the size of capital at risk. This is, if you like, the IMF's assessment of the unrealised losses in the European banking system as a result of the sovereign debt crisis.

Small wonder that many European banks can no longer access private funding markets. Small wonder too that European governments are so alarmed at this assessment, statement of the bleedin' obvious though it might be. Another round of bank bailouts so soon after the last one is anathma to most Europeans, worse, in some respects than the idea of bailing out sovereign nations directly.

Yet if this crisis is ever to be resolved, the IMF is surely right in asserting that recapitalisation of the banks is one of the first things that needs to happen. Most people will find the idea that more than four years after the banking crisis began, the banking system continues to require squillions of public money almost beyond belief.

It was reasonable to assume that the balance sheet problems of most banks had been "cured". Plainly they have not. Indeed the process seems barely to have begun. The danger of not recapitalising banks is that they will choose instead to boost their capital buffers and solvency through further deleveraging, which would in turn prompt a second credit crunch. Unpalatable though it is, governments must act.

As the IMF Stability Report warns, "Time is running out to address existing vulnerabilities. The set of policy choices that are both economically viable and politically feasible is shrinking as the crisis shifts into a new, more political phase". Quite so.

No, Mme Lagarde – forced recapitalisation would be exactly the wrong policy

Christine Lagarde (Photo: Reuters)

IMF chief Christine Lagarde has said that many European banks need “urgent recapitalisation” and a “mandatory substantial recapitalisation” would be the “most efficient solution”. This is wrong.

Banks are subject to regulatory capital requirements. That is to say, they are required to hold a certain amount of capital as a buffer so they can absorb losses if there are bad debts. There are three kinds of reasons for this.

The best reason is that, under some circumstances intrinsic to the nature of banking, a bank may face temporary liquidity problems and need to borrow money from the central bank (e.g. the ECB) on a “lender-of-last-resort” basis. The central bank will only want to provide such liquidity if the bank is a worthy recipient. Part of being a worthy recipient is that the bank concerned will be able to pay back the money. So the central bank should oversee the banks that it might provide last resort lending to ensure that they hold adequate capital.

The second reason is that individual depositors and shareholders in banks may be small, and not well-placed to monitor and discipline the activities of a large bank. Instead, they have incentives to free-ride on the monitoring of others. To get around this, the regulator acts as a “representative” of the depositors and small shareholders, monitoring the bank on their collective behalf, trying to ensure it has adequate capital (inter alia).

The third, and much weaker, reason for capital requirements is to try to avoid a financial crisis when a bank goes bust, which could lead to spillover effects on other financial institutions and perhaps the wider economy. There is thus perceived as being a social interest in capital being adequate that goes beyond the banks’ own interests – so banks may be required to hold more capital than they would, left to themselves, choose to do.

Let us consider Mme Lagarde’s proposal in the light of these three criteria. First, we should observe that capital requirements are determined at levels that reflect a current state of the market (number of players, size, etc) and aim to avoid a crisis arising. Once we are actually in a crisis they don’t apply in the same way. For example, once we are actually in a crisis the optimal future shape of the sector (number of players, size, etc) is likely to be different. Insisting on capital requirements that reflect the old shape is an exercise in denial. If a number of firms were to go bust, for example, then the share prices of the survivors would rise (as they would face less competition). So firms that would survive do not, themselves, need additional capital – imposing increased capital requirements on them will make them distressed artificially, through regulatory fiat. And firms that should not survive don’t need it either – they need to go bust and be taken over or restructured.

Next we should understand that if banks are value-destroying enterprises (as a number of European banks surely are) their solvency problem is not simply one of past losses. Their problem is a lack of future profitability – their businesses are not viable and need to be restructured or shut down. Recapitalisation in such circumstances is simply a matter of throwing good money after bad and of retarding the process of restructuring.

Third, we should understand the broader macroeconomic impact of demanding additional capital. Banks deliver this in two ways: first, they shrink their existing balance sheets (i.e. they make less loans, less risky loans and call in loans they have made); then, once they have de-risked, they raise extra money. Increasing capital requirements will tend to lead banks to draw in their claws further, shrinking the money stock and worsening the recession. Doing this now would very probably induce a catastrophe.

Banks do not need increased capital requirements. Instead, they need proper resolution mechanisms, whereby they can be allowed to go bust, safely, with losses for lenders instead of taxpayers and the wider macroeconomy.