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Greek Default Sooner, Better

Bank insolvency and bankruptcy is treated like it never happens. But it does...
FOLLOWING a Greek government default, and possibly before then, Greek banks would likely be both insolvent and unable to make payments to creditors, writes Nathan Lewis at New World Economics in this story first posted at Forbes.
What should a government do?
A bank becomes "insolvent" when the value of its assets is less than its total liabilities. In time, the bank also becomes "illiquid" – unable to borrow money, and thus make payments – because people don't like to lend to insolvent entities. Greek banks have been getting by because they have been able to borrow from the European Central Bank, but this may come to an end soon, perhaps in a matter of days.
There are two basic ways to deal with this: one is to increase assets, possibly through a government investment. This is called a "recapitalization," and when the government is involved, a "bail-out." Obviously, this takes money – €48 trillion in the case of Greece's prior government "bail-out" – and often the terms of the investment are so poor that it amounts to a gift to the bankers and their creditors.
The other way is to decrease liabilities, which obviously means some pain for the bank's creditors, including depositors. But, once this accounting adjustment is done – it amounts to a revision of ledgers, and could conceivably be accomplished in a day or two – then the bank can reopen for business, in good financial health. This process is sometimes known as a "bank holiday", a euphemistic term which shows that, when the financial system is temporarily shut down, there isn't much to do except spend the day at the park.
Bank insolvency and reorganization – a subset of bankruptcy – is one of those things, like sovereign default itself, which is treated as something conceivable, like a catastrophic earthquake in Los Angeles, but which never actually happens. This is wholly incorrect. The Federal Deposit Insurance Corporation, which oversees this process in the US, lists 513 failed banks since the start of 2008.
In the case of these US banks, typically the insured depositors are made whole; uninsured depositors and other creditors take a partial or complete loss; and the assets, liabilities and operations of the banks are sold to some larger bank. The bank quickly reopens, typically under the name of the acquiring bank, but the branches are the same. People with deposits at the bank at the time of its failure then have deposits at the acquiring bank.
This process typically costs the FDIC nothing, as insured deposits are well under the value of remaining assets. Ultimately, it amounts to an adjustment of ledgers. (A whole chapter is devoted to these topics in my book Gold: the Monetary Polaris.)
One of the largest banks to undergo this FDIC resolution process was Washington Mutual, which was closed by the Office of Thrift Supervision in September 2008. At the end of 2007, the bank had assets of $328 billion, deposit liabilities of $188 billion, 2,239 retail branches, and 43,198 employees. The bank was quickly sold to J.P.Morgan Chase; former Washington Mutual branches reopened with Chase signage, and former Washington Mutual customers became Chase customers.
As of March 2014, the entire Greek banking system had roughly €319 billion of assets among 19 Greek institutions, with 93% of this held by the top four banks. Including also branches of foreign banks, there were 2,688 branches and 45,654 employees.
In other words, the entirety of the Greek banking system is roughly equivalent in size to one Washington Mutual – to say nothing of the other 512 banks the FDIC has reorganized in recent years.
As is the case in many kinds of bankruptcy, there is, alas, great potential for criminality in these matters. This criminal element has already been codified in the "bail-in" legislation passed in most developed countries worldwide, including Greece. The "bail-in" legislation bypasses already-existing bankruptcy court processes – in other words, the systems formerly in place, flawed as they may be, to prevent widespread looting of the un-rich, un-powerful, and un-connected.
Most overtly, recent "bail-in" guidelines agreed to at the G20 meeting last November specifically make derivatives liabilities senior to uninsured deposits. It is practically a guarantee that noninsured depositors in large, derivatives-issuing banks will get screwed. It would also be Armageddon for money-market funds, which today are mostly conduits for junior bank financing. However, as ugly as that is, it might not be such a problem with smaller banks such as those in Greece, which typically do not have major derivatives involvement.
(The G20 agreement also makes "liabilities that the bank has by virtue of holding client assets" junior to "any liability, so far as it is secured," which seems ripe for abuse.)
It would be good if the Greek government brushed up a bit on what all of this means, before being led to slaughter by seemingly-helpful foreign advisors.
Greek banks need to go through their restructuring process. This will mean losses for some bank creditors, although they may get equity in a debt/equity swap, thus becoming shareholders in the new, healthy bank. The banks themselves do not need to be merged, sold or liquidated, but can continue much as they are, keeping the assets (loans) that they already have. They should be able to reopen in as little as a few days, emerging from the process as clean, healthy banks – perhaps among the healthiest in Europe. There should be no cost to the government.
Governments do not need to fear this, or, for that matter, abandon it to the guidance of foreign entities that do not have the best interests of Greeks at heart. Instead, governments should guide the process towards its best possible outcome: a tolerably fair distribution among creditors of the losses that already exist, prevention of further criminal asset-grabbing or liabilities-dumping, and a quick return to banking system normalcy.
It is a lot to ask a government to manage both a sovereign default and a banking system reorganization, all the while keeping an eye on popular support and amicable foreign relations. But, sometimes it needs to be done. All the alternatives are worse. So, do it.

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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