Cyprus: Bailing in and capital controls

Three European countries with oversized banking sectors have suffered major bank failures. Two of them are in the Euro Zone (Ireland and Cyprus) and one has its own currency (Iceland). Iceland and Cyprus imposed temporary capital controls, while Ireland did not. Iceland imposed losses on the foreign depositors in its large, failed banks while Ireland, under EU pressure bailed out everyone (even bond holders) except the shareholders.

The jargon used to describe much of this—“bail outs,” “bail ins,” “haircuts,” “good bank bad bank splits,” etc.—can be confusing. In this note I attempt to clarify the key concepts and their importance via the examples of Iceland, Ireland and Cyprus.

Market discipline vs. supervision and regulation

Incentives always matter. Banks, like any other business, are in business to make money. But the amount of risk they take (more risk more return—ON AVERAGE) depends on who regulates their behavior. Fundamentally, the market can regulate bank risk taking—by the willingness of investors to lend to banks and of depositors to place their money there—or the government can.

The last century has seen a steady shift away from market regulation toward government regulation. Deposit insurance is an important factor contributing to that shift by removing any concern by smaller depositors of the condition of their bank. Thus deposit insurance requires a substitution of the due diligence that used to be performed by small depositors with increased government regulation of bank risk taking. In the United States, the Federal Deposit Insurance Corporation (FDIC) provides much of that supervision and regulation.

However, increasingly countries became unwilling to allow banks to fail. While shareholders might be wiped out when a bank became insolvent (i.e., when the value of its assets fell below that of its deposits and other liabilities), country after country have “bailed out” all other bank creditors, including uninsured depositors. Bailing out depositors and other creditors means giving taxpayers’ money to the bank to make up for its losses and thus cover its liabilities (other than shareholders).  For large, “systemically important” banks (meaning banks whose failure could cause fatal losses in other banks or firms), most countries are not willing to let them fail at all, thus bailing out shareholders as well in order to allow the banks to continue to operate. Hence the problem of banks that are “too big to fail.” Bailing out uninsured depositors made deposit insurance redundant and pointless. Market discipline was pushed aside all together. The safety and soundness of banks came to rest almost completely on the adequacy of regulations and the skills of supervisors. Bank owners, the only ones who care any more, now have a financial incentive to take big risks for potential big gains. If they lose, as they do from time to time, the government, i.e., tax payer, will pick up the bill.

It is desirable to shift more of the discipline of bank risk taking back to the market by convincingly putting bondholders and large, uninsured depositors at risk of loss if their bank becomes insolvent. They have a financial incentive to get it right that supervisors do not.

Resolution of insolvent banks

Best practice when a bank becomes insolvent is to resolve it quickly and fully and to put a large part of the cost of its losses on uninsured creditors (shareholders, bond holders and uninsured depositors in that order).  Normal company bankruptcy can take the form of shutting down, locking the doors, and selling off anything of value (normally taking a few years) and distributing the proceeds to the creditors in the order of the legal priority of their claims. It is a transparent and objective, but slow process. In many instances the highest value for a failing company is obtained by selling it whole or in part to another company that is able to run it more efficiently. The recent bankruptcy of Sara Lee and sale of its best products to other companies is an example.

The bankruptcy and resolution of an insolvent bank is more challenging because of the ease with which depositors can run when they sense trouble. Thus the weekend sale of such banks in whole or in part to another bank is the norm for small or medium-sized banks in the U.S.  The good bank bad bank split, as occurred recently in Cyprus, is a recent example. Laiki became the bad bank that was closed and is being liquidated and the Bank of Cyprus became the good bank. After wiping out its shareholders and bondholders and administering a large haircut to the uninsured depositors, it acquired the insured deposits of Laiki and an equivalent value of good Laiki assets. Such bank resolutions, which freeze depositors’ funds only for very short periods (a few days), require special bankruptcy laws for tailored for banks. As the surviving good bank must continue to operate with little to no interruption, more judgment and uncertainty is involved in valuing the assets that it acquires from the bad bank.

It is instructive to look more closely at the resolution process used in Cyprus. First, the two major banks in Cyprus, Laiki and Bank of Cyprus, incurred large losses on their holdings of Greek sovereign debt when all banks were required to “voluntarily” write off about 75% of its value. The magnitude of this loss was clear and well-known from October 2011. The only issue was who would pay for it, the Cypriot government, the EU, or the creditors (depositors) of these banks. Depositor’s obviously thought that they would be bailed out (i.e. that the Cypriot government or the EU would pay for the losses of Laiki and Bank of Cyprus) as had been all depositors in Europe before them, though the deposit liabilities of the Bank of Cyprus fell from 37.1 billion Euros at the end of 2010 to 32.1 billion at the end of 2011 to 28 billion at the end of September 2012 (the latest available).

After a terrible false start in which the Cyprus government attempted to pay for the losses by levying a wealth tax on all depositors (of good and bad banks), Cyprus choose to impose the entire loss on the respective banks’ owners and creditors, and to undertake the good bank bad bank split briefly described above (see my earlier blog on the subject: This was a dramatic change in approach that shifted the risk of bank behavior back to uninsured depositors. Many were shocked.

This approach is relatively easy for known losses and should have been undertaken a year and a half earlier when the Greek debt write off occurred. But many of the losses a bank has or is incurring are less clear. Of the currently delinquent mortgage loans, for example, how many will actually default and what will be the market value of the mortgage collateral. The recapitalization of insolvent Irish banks suffered from underestimation of the ultimate losses resulting in three separate injections of state money to recapitalize them, which weakened market confidence in the process. In part to deal with this uncertainty but to restore market confidence in the solvency of the surviving good bank (Bank of Cyprus), known losses were totally written off while the additional but uncertain further losses were covered by replacing an equivalent amount of deposits with equity claims on the BOC (shares). If losses turn out to be smaller than was provided for, these claims will have value and will thus reduce the size of the initial haircuts to deposits.

So “bailing out” a bank refers to covering its losses with someone else’s money (tax payers somewhere) and “bailing in” a bank’s creditors refers to covering its losses (after its capital is used up) with bondholders and uninsured depositors’ money via “haircuts” (writing off part of their value). The former “socializes” losses while leaving any gains from successful bets to the private owners and creates a serious moral hazard leading to excessive risk taking by banks. The latter makes depositors financially responsible for excessive bank losses and restores the market’s discipline of bank risk taking. This is very desirable as market discipline is more effective than regulatory discipline, but the dramatic change in the implicit rules in Cyprus was very large and abrupt.

Capital controls

As part of their respective bank resolutions, both Iceland and Cyprus imposed temporary capital controls, which, however, served very different purposes. Iceland has its own currency while Cyprus is part of the Euro zone.

At the time of Iceland’s banking crisis in 2008 its three largest banks had assets 11 times the total annual output of the economy. About half of their assets (largely loans) and their funding were outside of Iceland. Landsbanki, for example, funding its lending with roughly the same amount of borrowing and deposits (a highly risky strategy). When the borrowed funding of these three banks dried up, their size made it impossible for the Icelandic Central Bank (ICB) to provide their needed liquidity (much of which was in the Euro, a foreign currency), resulting in the failure of all three banks in the second week of October 2008.

Iceland honored all insured deposits domestically and abroad but moved all domestic deposits into newly established “good” banks from the three now bad banks, while leaving their overseas, uninsured deposits in these three banks in receivership. To the extent that these banks failed because of illiquidity (the cut off of their borrowed funding), the receivership should be able to recover all losses to depositors from the liquidation of the banks’ remaining assets.

The UK and Netherland’s objected to the unequal treatment of the uninsured deposits of Icelanders and of foreigners. While Iceland’s decision to bail out all of its domestic depositors may be questioned because of the moral hazard it perpetuated, they had no legal obligation to do the same for Euro deposits by foreigners. The UK and the Netherlands stepped in and followed the same policy adopted by Iceland by guaranteeing the deposits of their citizens. They then tried to collect the cost of these guarantees from Iceland, a very questionable claim.

As the three new “good” banks were fully capitalized, they should have been able to withstand any level of deposit withdrawal as long as the ICB was able to provide any liquidity needed against the good but illiquid assets of these banks. The return of depositor confidence to the banks invariably takes time and some depositors wanted to withdraw their funds. However, because Iceland has its own currency, nervous Icelandic depositors wanting to move their bank deposits abroad, would need first to convert them into Euros or U.S. dollars, which would have depreciated the international value (exchange rate) of the Icelandic króna, and depleted ICB’s international reserves. A depreciation of the króna would raise the cost of imports and reduce the standard of living in Iceland. To protect the exchange rate from excessive devaluation, the ICB imposed temporary limits on the amount of money its residents could move out of the country. These capital controls are still in effect.

Lucky Cyprus is in the Euro zone.  After recapitalizing its banks, in part by writing down their deposit liabilities, they should have sufficient assets to cover all of their deposit liabilities and thus to cover any deposit withdrawals. The only issue would be whether the BOC’s assets were sufficiently liquid to cover the withdrawals. Within the Euro zone payments outside the country are made via the Target Payment System. A transfer of deposits from the BOC in Cyprus to a bank in any other Euro zone country is made by debiting the BOC’s clearing balance with the Central Bank of Cyprus (CBC) and crediting the recipient bank’s clearing account with its central bank via Target. If the BOC does not have sufficient funds in its clearing account with the CBC and is unable to sell sufficient assets to increase that balance, it can borrow the funds from the CBC using its good but illiquid assets as collateral. The CBC is able to do the same by borrowing from the European Central Bank (ECB), which is prepared to lend unlimited amounts against good collateral now that Cyprus has undertaken the measures required for the troika’s financial support (i.e., from the EU/ECB/IMF). There is no exchange rate issue or concern. It is purely a matter of the solvency and liquidity of Cypriot banks.

However, establishing sufficient liquidity to fund large deposit withdrawals may take a few weeks or months and thus Cyprus has imposed temporary capital controls that limit the amount of money that may be withdrawn each day as cash or by transfer. If the arrangements enjoy sufficient public confidence in the soundness and viability of the surviving Bank of Cyprus, the deposit withdrawals should be modest. The period of limits on withdrawals should be measured in weeks rather than months or years.


The resolution of Cyprus’s insolvent banks ultimately, after a false start, was achieved by bailing in its creditors. The resolution was relatively quick and seems complete. While Cyprus’s economy is likely to suffer its abrupt adjustment for some time, its banks should now be sound. The dramatic shift of the responsibility of regulating the risk taking of banks to their uninsured depositors, should, if it is maintained throughout Europe despite nervous claims that it is one-off and not a model, restrain excessive risk taking by banks and lead over time to a stronger banking system. In the interim, there may be some disruptive deposit shifts as previously reckless banks are forced by the market to clean up their acts.

The Cyprus Game Changer

Early banks were established by wealthy men that depositors could trust to return their money when they wanted it. Bank owners had unlimited liability for the trust placed in them. Any losses that exceeded what the bank owed its creditors (primarily depositors) had to be made up from the personal wealth of their owners.

With the introduction of limited liability banks, bank owners invested in significant amounts of capital (the difference between the value of the bank’s assets and liabilities) to reassure depositors that the bank was safe. They also advertised the conservatism with which they lent and invested depositor money. Some countries granted bank owners a liability limited to double the capital they paid into the bank in order to increase depositor protection without tying as much money up in capital.  In the much of the nineteenth century in the United States banks held capital well above 50% of their loans.

These early experiences with banking without any deposit insurance or any expectation by depositors that someone would bail them out (repay their deposits) if the bank failed (failure was the result of the bank not having enough money to repay depositors), maximized the market’s discipline of bank risk taking. Depositors paid close attention to the safety and soundness of the bank they put their money in.

During the great depression, the U.S. and most other countries introduced limited deposit insurance for small depositors thought to be too unsophisticated to evaluate the soundness of their banks. Such deposit insurance pretty much eliminated bank runs by panicked depositors. The level of deposits covered by insurance has risen considerably in most places (in the U.S. it is $250,000 and in Europe 100,000) thus reducing market discipline to some degree.

But outside of the United States, where the Federal Deposit Insurance Corporation (FDIC) has broad intervention and resolution powers to take over insolvent banks and to keep them going (if that is the least cost resolution) by reducing shareholder, bondholder, and uninsured depositor claims, almost no country allows its banks to fail (though this has begun to change in the last decade or two). If a bank experienced large enough losses that it became unable to pay off its depositors (i.e. became insolvent), governments would almost always bail it out one way or another. Depositors never lost anything. This practice and the market expectation it created made a joke of limited deposit insurance (because ALL deposits were implicitly guaranteed) and significantly reduced market discipline of bank behavior. This required more active supervision and regulation of banks to take the place of market regulation.

After a very bad start in Cyprus last week (see my blog from last week: the resolution of Cyprus’ two largest banks, Cyprus Popular Bank and the Bank of Cyprus, is taking the form intended by the banking law. Rather than bailing out the bank (the Cyprus government doesn’t have the money to do so, hence its need to turn to external help –EU/IMF/ECB and to accept the conditions attached), the shareholders, bondholders, and uninsured depositors (in that order) are being bailed in to cover the losses. The insured deposits of the Cyprus Popular Bank, aka Laiki, will be transferred to the Bank of Cyprus along with good assets of equivalent value. Laiki, the “bad bank”, will be put into receivership and its uninsured depositors will receive whatever value can be realized from the sale of its remaining assets (they are expected to lose about 80% of the value of their deposits). The Bank of Cyprus, the “good bank”, will continue to operate but will be recapitalized by wiping out the shareholders, bondholders and about 40% of the value of uninsured deposits. Depositor risk and the market discipline it provides to banks has returned with a vengeance. Hopefully this will be the practice throughout Europe going forward, which could then stop ignoring its no bailout rule.

In a Financial Times interview Jeroen Dijsselbloem, the Dutch finance minister and Eurogroup chairman stated that: “If we want to have a healthy, sound financial sector, the only way is to say, ‘Look, where you take the risks, you must deal with them, and if you can’t deal with them you shouldn’t have taken them on….’ That’s an approach that I think we, now that we are out of the heat of the crisis, should consequently take.”

This is a very promising change in European attitudes. Sadly it shocked so many EU officials that Mr. Dijsselbloem had to back track by saying: “Cyprus is a specific case with exceptional challenges which required the bail-in measures we have agreed upon yesterday. Macro-economic adjustment programs are tailor-made to the situation of the country concerned and no models or templates are used.” (quoted in the March 26 WSJ “Shocked about Cyprus”) The big unknown is whether this was too rapid a restoration of market discipline. Changing the rules is always problematic and government explanations to their publics of the situation and their policies for dealing with it have been poor to date. The coming days will be interesting indeed.

Cyprus and the Euro

Does the Euro need to be supported by closer European fiscal integration? Many countries do just fine without their own currency and no fiscal coordination with their currency’s issuer. Panama has used the U.S. dollar for well over a century with good success. Ecuador and El Salvador have used the dollar as their own currency for a much shorter time and are doing better for it. Etc.

The major failing of the Euro, along with its considerable benefits for the Euro zone countries and those doing business or traveling among them, has been the failure of lenders to properly price the risk of lending to the Greece’s and Italy’s of the world. The spread between Greek government bonds over German government bonds collapsed to near parity after Greece replaced its inflation prone currency with the low inflation Euro. Greeks, both private and public, responded by borrowing with abandon. Greece has many other structural problems that keep its productivity lower than its neighbors, but credit markets indulged its borrowing binge on the assumption that there was little to no risk that the Greek government would be allowed to default on its debt.  This gave Greece the illusion of a higher standard of living for a while. Richer brothers to the north would surely step in and bail it out if it couldn’t repay its debts. And so it was for a while.

Against German resistance, Greece finally defaulted on much of its debt (the so-called voluntary haircut – write down — of its debt held by banks to about 30% of its full value). This was an important restoration of market risk and hence market discipline of Greek and other EU periphery countries’ borrowing. It will potentially help save the Euro. Most banks were able to absorb their resulting loss, but some big Cyprus banks apparently were not.

The EU/ECB/IMF (the troika) have offered conditional financial assistance to Cyprus but not to cover the cost of recapitalizing Cyprus’s underwater banks. Cyprus is required to raise those funds themselves. At least this is my assumption. Press reports on what the external support covers are almost totally lacking and the conditions for the deal are not yet final anyway. There is a relatively straightforward approach to resolving these banks, though the details would depend on the particulars of its banking and bankruptcy laws. I do not know the details of these laws nor of the conditions of these banks (Laiki and Bank of Cyprus), but I assume that they are viable if recapitalized and worth more as going concerns than from liquidating them.

The insolvent banks should be put into receivership and instantly split into a good, fully capitalized, bank and a bad bank (i.e. what ever is left) to be liquidated. The good banks would be fully capitalized by leaving some of their liabilities with the bad bank, starting with its shareholders, then bondholders (of which there are not many), then uninsured depositors. These creditors would, in effect, be written off. This would enable the new good banks to continue operating without serious interruption. The only real debate should be about how far to cut into depositors (so-called bailing creditors in) to rebalance assets and liabilities. The Economist argues that the write-offs should stop with shareholders and bondholders and all depositors should be made good via bailout funds from the European Stability Mechanism.

Depending on the particulars of the banking law, an insolvent but otherwise viable bank is put into receivership. This removes the shareholders from any control over the bank. Immediately the good assets of the bank, including its branch network and equipment, and staff would be sold to a new bank, which would assume all insured deposits and a proportionate amount of the uninsured deposit sufficient to match the value of the assets purchased. Ideally the new bank would be sold immediately to new private owners. But if more time is needed to organize its sell, it would be sold temporarily to the government for one Euro. What remains of the old bank would be liquidated and the proceeds would be apportioned in accordance with the priorities provided in the law to the credits (deposits that were not transferred to the new bank). As all of the good assets were transferred to the good bank, there would be virtually no further assets in the bad bank to recover and the remaining creditors would receive little to nothing.  The overall loss to depositors will depend on the losses incurred by the bank on its assets that made it insolvent in the first place. The orderly resolution described above almost always result it much smaller losses to creditors than a disorderly default in which the bank closes its doors totally.

Market discipline would clearly be more strengthened if uninsured depositors were also at risk of losing money. But increasing that risk unexpectedly and to too large an extent could cause deposit runs throughout Euro (and the world). Ultimately, but maybe not at the moment, this would be a good thing for the banking sector. Banks would have to behave more prudently or run the risk of losing deposits. Such market discipline is more effective in limited excessive risk taking by banks than is tighter supervision; though required capital and senior convertible bonds should be significantly increased in the future. In my view, the full recapitalization of all insolvent banks should be financed by bailing in as many uninsured depositors as needed to cover their capital deficiency. The IMF’s position, opposed by the EU, was that a good bank should assume only the insured depositors and receive sufficient good assets to cover them. This would leave all uninsured deposits in the bad bank, which were expected to suffer losses of 20 to 40 percent of their value.

The Cypriote officials originally proposed something quite different. They proposed a one-time levy on all depositors with a lower tax rate on smaller insured deposits. Thus both insured and uninsured depositors in good banks as well as bad ones would be paying to cover the losses of insolvent ones. Not exactly a boost to market discipline of banks. Depositors everywhere and especially in the Euro zone were shocked and the Cyprus Parliament rejected the proposal.

It will be interesting to know what motivated this crazy idea. For one thing it protects the shareholders from the loss of their shares and control of their banks, which is not a good idea from the point of view of the health of the banking system, though it may have been a deliberate goal of the plan (the shareholders are likely to be influential people in Cyprus). Antonis Samaras, the President of Cyprus, suggested that he wished to diminish the loss to large depositors (which include many wealthy Russians, some of whom have dealings with his law firm). Steve Hanke states that about half of Cyprus banks’ deposits are owed to Russians (including those of Russian subsidiaries established in Cyprus).

Whether lightening the burden of large depositors (sharing the burden more equitably according to the President) involved murky deals with Russians or the mistaken belief that it might save the large offshore deposit business Cyprus had developed (the deposit liabilities of its banks were eight time Cyprus’s GDP) only time will tell (maybe). Cyprus’s banking business is more like that of Iceland or Ireland before they crashed and burned several years ago, than the typical off shore financial centers like Cayman. The deposits in Cyprus are with Cyprus banks. If they become insolvent, depositors (or tax payers somewhere) lose. Foreign depositors in Cayman banks are actually depositing in branches of international banks with headquarters and assets elsewhere. Loses incurred by Cayman branches would be a small fraction of the total assets of the global bank and more easily absorbed.

Cyprus’s misguided attempt to spare large depositors at the expense of depositors in general, even if rejected in the end, greatly unnerved depositors everywhere and is likely to weaken rather than strengthen market discipline of bank risk taking.  By making the depositor haircut a levy/tax, Cyprus intended to bypass the bankruptcy/resolution provisions of the banking law and deposit insurance provisions. They created a mess.

Spain’s Financial Crisis: First Principles

Europe’s debt crisis has many contributing elements: bloated government bureaucracies, unaffordable social welfare programs, and productivity stifling labor and commercial laws.  However, none is as central as the condition and behavior of those European banks that overlent to and undercharged many European governments, and whose potential insolvency should one or more European governments default (as Greece has already to some extent) has dominated the EU’s slow, halting approach to dealing with it. Focusing on the case of Spain, the following note illustrates the importance for the future of Europe’s financial markets of resolving the banking sector’s problems properly.


In some respects the financial and debt situation of Spain is similar to that of the U.S.[1] Its central government debt is less than the U.S.’ and Germany’s (68%, 103%, and 83% respectively). This year its public sector deficit is expected to be 5.9% (8.5% last year), less than the U.S. at 7.6%, but more than Germany’s at 1.3%. Its total debt (public and private) to foreigners (external debt) is less as well (84%, 103%, and 142% respectively). Spain’s housing bubble and subsequent collapse were average. The decline in Spain’s real housing prices from their peak in 2007 of about 20% was about the same as the UK’s and the Euro zone’s and less than in Ireland and the U.S.

To over simplify, what sets Spain apart is a) its lack of competitiveness (its current account deficit with the rest of the world relative to GDP was 9.6% in 2008 and is currently almost 3% while the Euro area as a whole is balanced – i.e., 0); b) the heavy reliance of its banks on borrowed funds (its loan to deposit ratio is about 150% compared with 80% for U.S. banks; and c) its banks’ large exposure to the real estate and construction sectors (56.5% compared to 30% for U.S. banks). In addition, Spanish and European banks in general operate on much less capital than do American banks. Going into the recent financial crisis—2007—the ratio of total European bank assets to capital—i.e., the leverage ratio—averaged around 30, while for American banks it averaged around 13 (i.e. capital gearing ratios of 3.3% and 7.7% respectively).

Spain was confident that it could make sufficient budgetary and policy adjustments to convince markets that it was still safe to lend to while gradually winding down excess spending and liberalizing rigid labor and product markets (its no bailout strategy). But after four years of inadequate measures Spanish voters ousted the Socialist Party and gave the center right party of Mariano Rajoy a solid majority in Parliament with a mandate to move more aggressively. Prime Minister Rajoy’s reform program has been a mixed bag (see “Spain’s Economic Reforms: A Mixed Bag”). The central government’s spending and deficit are falling rapidly, though excessive regional government spending remains a problem. Labor market reform has been quite quick and strong and is already producing improvements in competitiveness. However, Spain has fallen back into recession and unemployment is the highest in Europe at over 24%.  (see Rajoy government reform program)

Spain’s Banks

Spain’s primary vulnerability comes from its banks. In fact, a central feature of the European debt crisis is the relatively large exposure of European banks, including German banks, to the sovereign debts of Greece, Portugal, Ireland, Italy, Spain, etc. If depositors think that their deposits are at risk, they will move them. If they think all banks in Spain suffer this risk, they will move them out of Spain to other banks that accept Euros. If depositors withdraw their deposits too rapidly (i.e., bank runs) then even solvent, well capitalized banks can have trouble liquidating assets fast enough to fund the withdrawals. The total deposits of Greek banks have fallen from 245 billion at the end of 2009 to 175 billion at the end of April 2012. However, Spanish banks’ deposits have not begun to decline until very recently.

Countries limit the risk of deposit runs by explicitly insuring bank deposits up to a limit and/or by standing ready to intervene (bailout) failing banks. In Spain, all deposits are insured up to 100,000 per depositor. If governments guarantee all deposits as a result of a comment to bail out insolvent banks, deposit insurance is redundant and not needed. Even a full deposit guarantee provides some market discipline of bank behavior if the regulator intervenes promptly when a bank becomes insolvent, because shareholders lose all of their investment in the bank. Market discipline is strengthened further if bank bondholders also incur losses when the assets of an intervened bank are not sufficient to cover their repayment.

The Importance of Bank Capital

Without deposit insurance or government deposit guarantees, their bank’s capital is the primary protection for depositors against the risk of loss.  If depositors think that their bank’s capital is too low to cover potential losses, they will move their deposits to safer banks. Unfortunately, the value of a bank’s capital cannot be known with certainty. Economic capital (net worth) is the difference between the value of assets and the value of liabilities. A large share of banks’ assets is loans. The value of a loan is less than its face (book) value if it is not repaid fully or on time. It is impossible to know for sure which loans are “good” and which are doubtful and how doubtful they might be in the future.

Minimizing the risk of deposit runs via capital adequacy consists of three elements:

  1. The level of capital banks are required to hold in normal times (dynamic or cyclically adjusted capital requirements deserve more serious attention) must be sufficient to absorb possible losses. Higher capital requirements provide more deposit protection.
  2. The rules for valuing assets and thus capital must reflect their real value as best as possible. Most bank loans have no secondary market from which to measure their value. Thus bank regulators have established rules of thumb for estimating the probable loss in value for loans that are not performing or are at risk of falling into arrears and potentially defaulting. Banks are required to provision (write down capital) to cover such probable losses. This is the equivalent of “marking to market” the probable value of loans that have no market. Loan valuation and loan loss provisions need to realistically reflect and cover the most likely repayment outcomes.
  3. Depositors must have confidence in the adequacy of the first two measures and the faithfulness with which banks apply them. This is the issue of transparency. The recent deployment of stress tests, when properly explained (especially when undertaken by third parties, such as the IMF), is meant to reduce the uncertainty surrounding the adequacy of measured capital.

The risks to Spanish bank depositors come primarily from three sources:

  1. The potential losses from loans to Spain’s now busted housing and construction markets and from holdings of sovereign debt of Greece are uncertain and have almost certainly been underestimated and under provisioned in the past. Significant exposure to Spanish sovereign debt is now becoming an issue as well. Capital injections are needed just to keep actual capital at currently reported levels. Higher levels of capital are needed to compensate depositors for the uncertainty of the actual level of capital.
  2. The ability of Spain to honor its deposit insurance commitments or its implicit commitments to cover deposits in the event of an intervention are increasingly in doubt because the ability of the Spanish government to borrow additional amounts to cover such commitments is in doubt.
  3. The ability of banks to fund their loans from non-deposit sources or to fund deposit withdrawals even if they are well capitalized are in doubt in current market conditions. This is a liquidity problem, not a solvency problem, and should be handled by the provision of central bank liquidity.

Spanish banks fund a large part of their loans with relatively short-term borrowed money rather than deposits. Access to such funds has become difficult and expensive. From the beginning of central banking, a core function of central banks has been to provide banks with the liquidity they need in such circumstances. The long-established principle is that the central bank should provide illiquid but solvent banks with all the liquidity they need (generally by lending to them against good collateral), but should not lend to insolvent banks (banks lacking sufficient good assets to cover their deposit and other liabilities). The ECB’s three-year Long Term Refinancing Operation is addressing banks’ liquidity problem (#3).

But even without deposit runs (or walks), Spanish and other European banks (especially) need to reduce the extent to which they lend long-term on the basis of short-term borrowed funds. They can only do so by reducing lending until their deposits finance a larger share of it and/or by increasing capital. The bank deleveraging now underway around the world is an important source of reduced bank lending and the slow pace of recovery (see Carmen M. Reinhart & Kenneth S. Rogoff, “This Time is Different: Eight Centuries of Financial Folly”).

Spanish banks were better capitalized than most at the onset of the international financial crisis but more recently have been overwhelmed by the magnitude of the collapse of Spain’s housing and construction markets. The government (previous and current) has taken measures to address banking sector weaknesses but always a bit behind the curve.  Seven failing cajas (regional savings banks heavily exposed to real estate) were merged in 2010 to form Bankia making it Spain’s fourth largest bank. In May the bank was largely nationalized (costing the Spanish government around 20 billion Euros to date) and trading of its shares was suspended on May 25, 2012. Deposit insurance was established then raised. Government guarantees of senior bank bond holdings were introduced (October 2008).

As time passed, depositors have only become more concerned about the safety of their deposits. In an effort to finally get ahead of the curve, the authorities have increased the provisions required against weak and doubtful loans and other assets, and initiated third-party stress tests of its banks. The IMF’s recent Financial Sector Stability Assessment found Spain’s large internationally active banks to be well capitalized and able to absorb the new capital strengthening requirements. However, its former savings banks and some of its medium and small private sector banks are more vulnerable and will need capital injections from the government to cover insured or guaranteed deposits. Because of its own financing difficulties, the government of Spain has turned to the EU to backstop its ability to recapitalize (replace capital lost by or potentially lost by defaulting loans) those of its banks with inadequate capital. For this purpose the EU has committed 100 billion.

The Way Forward

Deposit runs on Spanish banks (including the drying up of wholesale funding) can be prevented only by convincing depositors that their money is safe, i.e. that their banks have sufficient capital to cover any losses. This requires honest accounting and full implementation of the indicated provisioning, and adequate capital; or creditable government guarantees.

For the future health of Spanish banks, it is important that Spain’s banking interventions preserve the intended discipline of excessive risk taking that results from imposing losses on shareholders and senior bond holders while honoring its commitments to protect depositors. Thus liquidity support should only be given to solvent banks. Nonperforming loans should be properly provisioned. Banks that are critically undercapitalized and are unable to raise their own capital to required levels within a reasonable period should be intervened. Intervened banks should be resolved according to the least cost principle (least cost to the tax payer). Shareholders and senior bondholders should be wiped out before government money is injected to cover other liabilities. Viable banks should be continued and sold to new owners within a reasonable period of time. Non-viable banks should be wound down (liquidated) paying off all insured or guaranteed depositors with the help of public funds as needed.

In requesting EU financial assistance, Spain is committed to abiding by EU rules on state aid to banks. However, emergency responses to a financial crisis much too often produce the foundation of moral hazard and excessive risk taking that creates the next crises delaying true and long-lasting resolution. More market discipline of risk taking needs to be reintroduced via a sound bank resolution policy. Spain will contribute to the future soundness and vitality of its banking sector and that of all of Europe if it adheres to the above principles as it “cleans up” its financial sector.

[1] The International Monetary Fund’s “Financial Sector Stability Assessment”  provides an excellent summary as of May 2012.