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Why Bank Holidays Could Soon Hit Europe

Alternative policies are reaching their limits – or are far more disastrous than closing banks for a few weeks...

THE VARIOUS attempts by European authorities to shore up banks' condition with phony financials and vast theft of public money would appear to be coming to an end, writes Nathan Lewis at New World Economics.

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 'bank holiday' is enforced to put a stop to market pressures," wrote Saxo Bank economist Steen Jakobsen in November 2011. He expected this to 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 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 US, 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 system wide 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 European Central Bank – 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.

This article was originally published at Forbes.

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Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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