We have written on numerous occasions about the hitherto inseparable links between sovereigns and banks, and we have also written about the benefits of writing down bonds to create capital (see The New Era for Bank Bonds: Send In The Clowns? and Equitisation of bank capital bonds) . In 2007 the global markets woke up to the fact that the US subprime market was blowing up, and in 2008 realised that due to financial engineering and securitisation, both of which were preposterously known at the time as ‘risk dissemination and minimisation’, banks the world over had major solvency issues as vast quantities of investments plummeted in value. This, in turn, led to a liquidity crisis as the investment markets shunned investment in banks and the interbank market froze over.
The crisis we are in today is the same crisis we were in 5 years ago. Sovereigns had to step in to guarantee their banking systems, so as to enable debt to be rolled over and confidence to return. In the short term the most important thing was to provide liquidity, which we saw through government guaranteed debt issuance and secured funding directly with central banks in the UK, US and more recently Europe. Next, sovereigns had to buy huge volumes of illiquid assets from their banks (US), or provide direct capital injections to support their solvency (US and UK), as the perception dawned that the liquidity crisis was caused by a solvency crisis.
All this time, the inevitable link between sovereigns and banks was becoming more and more deeply intertwined. And whilst it may feel that the Great Recession has metamorphosed from a banking crisis to a sovereign one, it hasn’t really: sovereigns took on increased liabilities to protect their banking systems and now find themselves in the ‘limelight’. It’s the same crisis, with a different focus.
Many European banks, though, remain substantially undercapitalised. Hence, the system is still overwhelmingly dependent on central banks to provide them with liquidity at an affordable cost. All the time the sovereigns providing liquidity are becoming more and more tied to the health or otherwise of their banks and the assets they are taking from them as collateral.
Has the time come for this cycle to end? Might the severance of this link bring the beginning of the end of the sovereign crisis? Many European banks are still on 24 hour life support, saddled by enormous levels of liabilities that are cutting off new lending and suffocating new investment through the multi-year crisis in confidence in lending to and investing in banks.
So how will this occur? Well my sense is that there’s abundant liquidity at the moment after all the LTROs, inter-central bank funding lines, secured lending facilities and covered bond new issuance. The problem is far more one of solvency and capital adequacy in Europe, where the very worst of the banking crisis continues today. For sovereigns to provide their national banks with the recapitalisations they need, via wholesale nationalisations, would only see a worsening of the sovereign debt crisis, as the funds would have to come from somewhere. So this approach doesn’t really work. And is it really desirable from the perspective of the taxpayer?
The solution? We need new capital, in substantial scale, and fast. The time may have come to sever a significant part of the link between a sovereign and its banks. Unsecured bank bonds in peripheral Europe where the sovereigns are struggling under high borrowing costs, and so where the cost of providing guarantees and funds to their banks are painful, should now be written down in certain cases. Both subordinated debt and senior unsecured bonds would see defaults, in some cases even to zero. This would generate huge amounts of capital (which writing down only subordinated debt would not achieve on its own), and does not involve the troubled sovereign having to borrow more from the markets or seeing debt / GDP levels spiralling. Yes this is painful for investors and to risk-taking savers who are exposed to bank bonds in their pensions and so who suffer losses there. But the write downs are taken. Capital is generated. Deleveraging of the system occurs quickly and substantially (at last!). And the severance of this part of the sovereign-bank link (deposit guarantees must remain in place) means that the banks might just stop dragging the sovereigns down with them.
Policymakers and politicians must be aware (and I’m assuming they are already) of the benefits of this first step towards cleansing the system. If this doesn’t work, then nationalisation is the last resort, and the taxpayer must step in one last time. But this situation of creeping nationalisation where taxpayers provide 24 hour life support in European banks through emergency policy response after emergency policy response, at the expense of much higher tax and lower quality of life across all citizens for a very long time feels wrong, at least before the risk-takers have suffered. Could now be the time for bank bondholders to see defaults, where they are needed? There are countries where these dramatic measures aren’t needed, as well as individual banks where they won’t be needed within troubled systems. The process will be painful for bearers of risk (investors and savers), but it might, more importantly, provide the capital the system so needs to start restoring confidence in the banks, and the sovereigns would benefit from cutting the tie with the non-deposit banking system. So policymakers have to work out whether society overall would be better off with this new approach than the current one. They may very well conclude that the present situation of taxpayers being subordinate to bank bond holders, rather than vice versa, is a morally repugnant system.
Some of us are damned if we change tack and take this approach. All of us are damned if we don’t.