Monday, 6 June 2011

The value of implicit bank guarantees

In an event little noticed outside of Denmark, the Danish FSA and the finance ministry let the country’s former fifth largest bank, Amagerbanken, go bust . This happened after a couple of attempts at recapitalising the bank. Remarkably, the holders of Amagerbankens’s bond debt were told that they could line up with other creditors to get their money back.

It has created quite uproar in Denmark’s financial sector, where previous bank collapses had been handled with “due respect” for the interest of bond holders. 

As a direct consequence, the international (read: the US) rating agencies have downgraded Danish banks several times since then, most recently at the end of May.

Predictably, Danish banks are lamenting the fact that the government has shown its willingness NOT to compensate bond holders.

Their spin is that the lower ratings mean higher funding costs and thereby a competitive disadvantage for Danish banks. So we are to believe that the FSA and the finance ministry willingly have weakened the position of the country’s own banks?

One could look at it differently. I have several times wondered why simple capitalist principles were not applied when it came to the banking sector. The answer is that a) the banks were much weaker than anybody outside the sector had expected and b) the banks have been very good at making politicians believe that it would be the end of civilisation as we know it if banks and their owners/creditors were to shoulder the burden of their own greed and recklessness.

If we look at it this way, Denmark is the first country that has shown the way forward (well, Iceland sort of did, too). If banks cannot survive with the capital they have, they go under. Those who had lent them money should take the losses, since money lending inherently is a risky business. That seems a very healthy principle for “bank resolution”, i.e. dealing with dead banks. And by the way, it was exactly what Sweden did during its systemic banking crisis in the early ‘90s.

But what about the increased funding costs, stemming from the absence of a government guarantee to the lenders?? 

The right way to look at this is not to bemoan the situation of the Danish banks, but instead look at the difference in funding costs as the market value of the implicit government guarantees. We are in a situation where banks in other European countries have higher ratings than Danish banks, simply because the governments are expected to pick up the pieces if another bank blows up. It could hardly be unhealthier.

I quote former US Secretary of the Treasury and Chief Economic Advisor to President Obama, Larry Summers, who in 2000 said:

“While conditioned, precautionary financial support is constructive in some cases, the risk inherent in systematic availability of unconditional credit to countries can be summarized in two words: moral hazard. ... It is certain that a healthy financial system cannot be built on the expectation of bailouts.”

Summers later minced his words in a quite spectacular way and helped engineering the biggest giveaway of taxpayer money in modern history. But that does not make his statement of 11 years ago wrong.

Banks’ funding costs should not be based on implicit guarantees. They should be based on the availability of a capital base sufficient for their activities. Incredible that it is so difficult to get this simple message across to the banks.

Well, an implicit guarantee does not weigh on the balance. It allows a higher financial leverage. And it creates the possibility of higher return to the shareholders and fatter bonuses to the bank management. Go figure.

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