Sunday 11 December 2016

An overhaul of Europe's pre-crash banking system is long overdue

Bank managers still have little to stop them incurring risks at taxpayers' expense.

Published 27/04/2014 | 02:30

When the US government decided to let Lehman Brothers go down in September 2008, it was an exceptional decision.
When the US government decided to let Lehman Brothers go down in September 2008, it was an exceptional decision.

Taxpayers will not get saddled with large public debts resulting from the rescue of failed banks unless three things happen first. The banks need to make losses large enough to exhaust their spare capital. The regulators need to do nothing to stop them incurring these losses. Finally the government needs to catch the falling knife, in order to protect the creditors of the banks.

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Banking is a risky business for lots of reasons but the main problem is called leverage. Bank assets, mostly loans to customers, are never risk-free and even prudent banks will have to shoulder heavy loan losses occasionally. But banks are not required to raise and retain large amounts of spare risk capital, the better to survive when things go wrong. Under the international rules in place before the crash, banks could lend €30 or even €40 for every €1 put up by shareholders and available to absorb losses. Unless the loans and other investments the bank has made are super-safe, it is likely that they will struggle in a bad year. Not all banks lent €30 or €40 for every €1 they had available to cover losses, but many lent €12 or €15. If the value of their loan assets took even a modest hit, they were likely to struggle. Their vulnerability to management lending errors derives from high leverage, which means excessive reliance on debt funding in bonds and deposits.

In the Irish bank bust, shareholders were more or less completely wiped out. The scale of shareholder losses was quite staggering, totalling several tens of billions, including amounts lost in the Irish banks but also the losses of shareholders in the Irish subsidiaries of British, Dutch and Danish banks. But it was not enough: the losses greatly exceeded whatever spare capital was available. This should not have happened if the first line of defence, bank managements, had been sufficiently cautious.

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