The Cyprus "bail-in" looks more than a little fishy...
A NEW STRATEGY has been unveiled around the world, with the first test run in Cyprus. Despite early denials, the "bail-in" strategy for insolvent banks has already become official policy throughout Europe and internationally as well, writes Nathan Lewis of New World Economics.
At first glance, the "bail-in" resembles the normal capitalist process of liabilities restructuring that should occur when a bank becomes insolvent. Equity investors and most-junior creditors lose everything; less-junior creditors get a debt/equity conversion, and senior creditors get 100%. The bank can remain in operation, and does not have to liquidate any assets. No public money is required.
I have been an advocate of restructuring insolvent banks according to these basic capitalistic principles, which requires no public funds.
The difference with the "bail-in" is that the order of creditor seniority is changed. In the end, it amounts to the cronies (other banks and government) and non-cronies. The cronies get 100% or more; the non-cronies, including non-interest-bearing depositors who should be super-senior, get a kick in the guts instead.
Here's what it looked like in Cyprus:
All insured deposits (individuals and legal entities) up to €100.000 have, as of 26 March 2013, been transferred from Laiki Bank to the Bank of Cyprus. In addition, the entire amount of deposits belonging to financial institutions, the government, municipalities, municipal councils and other public entities, insurance companies, charities, schools, educational institutions, and deposits belonging to JCC Payment Systems Ltd have been transferred to the Bank of Cyprus.
All other deposits exceeding €100.000 remain in the 'bad' Laiki Bank.
Did you get that? Financial institutions (e.g. German banks, and central banks including the Bundesbank) get full repayment, along with government entities, while everyone else gets to eat sand.
If you were robbing a bank, would you take only a little of the money in the vault? No, you would take all of it. The bankers see it the same way when they rob you.
Once you have performed the initial crime of sticking the losses with the non-crony creditors (who are generally senior), while the cronies (who are generally junior) get out scot-free, you might as well keep going.
This can take a number of forms. One is the possibility that the assets of the bank will be sold at firesale prices to other cronies. A "bad" loan might not be worth the full 100 cents on the Dollar, but it might have a reasonable economic value of 50 cents. Sell the loan to a crony for 5 cents, and the crony effectively gets forty-five cents of instant profit — a nice 10x gain. The losses are taken by the non-crony creditors. This is one reason why I generally do not recommend liquidation, but rather continuation as a going concern for insolvent banks.
Another strategy is loan write-downs. Crony borrowers effectively get loan forgiveness — you no longer owe any money! Indeed, the crony borrowers might get the loans (due to advance information) just before the bank's restructuring. The loan forgiveness ends up as losses for non-crony creditors. This has already happened in Cyprus, where investigations have already begun regarding loan write-offs for local lawmakers.
Then we have the "use-the-bank-as-a-dumpster" strategy. Another crony bank, which also has impaired assets, sells the assets to the failed bank at full price. The failed bank might use a loan, perhaps from the central bank, to pay for this purchase. After the restructuring, the central bank claims front-of-the-line status and gets all its money back. Again, the non-crony creditors eat the losses — losses which originated at another bank!
As it is, many banks in southern Europe have what amounts to large borrowings from the Bundesbank, in the form of "Target2" balances. These total more than €750 billion presently, indirectly owed by banks in Spain, Italy and elsewhere. The Bundesbank would claim front-of-the-line status on these borrowings as well, and again non-crony creditors, who would otherwise often be super-senior, eat the losses.
But we would never do that in the United States, right? Try this headline: "Citigroup Says Debt Beats Peers in Advance of 'Bail-In' Rule."
In principle, depositors are the most senior creditors in a bank. However, that was changed in the 2005 bankruptcy law, which made derivatives liabilities most senior. In other words, derivatives liabilities get paid before all other creditors — certainly before non-crony creditors like depositors. Considering the extreme levels of derivatives liabilities that many large banks have, and the opportunity to stuff any bank with derivatives liabilities an the last moment, other creditors could easily find there is nothing left for them at all.
A bank is a levered structure. It might have $10 of assets, $1 of capital and $9 of liabilities. If the value of the assets falls to $8, then the bank is insolvent. That would mean the creditors (liabilities) would have $8 to distribute among themselves. They would get $8/$9 or eighty-nine cents on the Dollar of debt and equity book value. Even then, most of the losses would be borne by junior creditors, and senior creditors should get a full recovery.
Let's give a real-life example: In December 1931, the Bank of the United States, a large commercial bank, failed in a wave of bank insolvency that claimed six hundred and eight US banks in just two months.
It was the Great Depression. Over six hundred US banks failed in two months alone. The assets of the Bank of the United States were liquidated into one of the worst markets of the twentieth century. It was, in other words, the worst imaginable situation to be a creditor to an insolvent bank.
Nevertheless, creditors eventually recovered $0.835 on the Dollar. Senior creditors probably got a full recovery. That's the way it is supposed to work.
This article originally appeared at Forbes.