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In the first part of this post I mentioned possible solutions to the moral hazard problem with banks. I forgot to mention what I think should be done right now in order to stabilize our financial system.

The pressing problem with our financial system is that banks are massively undercapitalized. The relation of debt to equity is somewhere between 20:1 and 60:1 for most banks in OECD countries. An average large bank like Deutsche Bank has over $2 trillion of assets/liabilities on its balance sheet, but only about $40 billion of equity. Equity is capital that is owned by a bank itself. Profits add to equity, losses diminish it. You may remember that many large banks lost several tens of billions of dollars during the height of the crisis 2008-09. If I remember correctly, the Deutsche Bank lost $15 billion.

So you see that it doesn’t take much to erode half of the equity and to push a bank into insolvency. Recently it was reported that German banks hold $75 billion of Greek debt. The recovery ratio on this debt may be well below 50% when the restructuring of Greek debt takes place. It’s easy to see why financial markets are still wobbly and why banks don’t lend much to each other. Many banks have to go to the ECB or the Federal Reserve to borrow money.

Although almost every economist on this earth knows (or should know) that the best solution to stabilize banks in the short-term is to give them more equity capital (which means that the government should buy into the bank), politicians in the USA and in most of Europe chose to concentrate on providing garantuees only. Meanwhile, central banks around the world are providing cheap loans to private banks, so that they can meet current expenses for a while. Of course, this can’t be a long-term solution. The Japanese have done it this way for over twenty years now, and their banking system is deleveraging, i.e. shrinking the debt-to-equity ratio. The way to deleverage is to offer fewer loans and to hoard as much earnings as possible. That’s assumed to be an important reason why Japan grew very slowly during the last 20 years. (BTW, if you buy into this theory, you should also subscribe to the theory that we need fractional reserve banking, and that a return to full reserve banking would lead to a horribly long depression [see How To Handle The Great Recession, Part I]).

However, only Ireland and Great Britain seem to have filled up their banks with more equity. The rest has chosen the Japanese path. I wouldn’t be surprised to see the Irish and British economies recover much faster than every other OECD country in the next 5 years. So, should others simply copy British policies? Yes, but: it’s not that easy. Even if the USA or Euro zone countries decided in favor of equity injections, they probably couldn’t do much because they already are so indebted. Look how fast the debt-to-GDP ratio grows in the United Kingdom. From 40% to 120% between 2008 and 2013. This kind of policy can push government on to the brink of insolvency, especially if they start at higher levels of debt-to-GDP ratios.

This is why many economists demand Quantitative Easing 2.0. It means printing many trillions of dollars and lending them to the banks for 0% interest and against all worthless collateral that banks can offer. This way, banks can unload their foul loans to the central banks or the government (which is basically the same, as the central bank would have to be backed by the government). The advantage of QE is that it doesn’t increase government debt (at least, not now). You simply print new money. However, it cannot solve the problem of high debt-to-equity ratios of banks immediately. Banks have to reinvest the printed money and make a profit out of it. The profit then adds to equity.

Now imagine a bank like Deutsche Bank. They would need $100 billion of equity in order to have a debt-to-equity ratio of 20:1. They are now $40 billion, so they would need $60 billion in profits. According to Wikipedia, they generated $28 billion of revenue in 2009. I think it’s easy to calculate that it would take many years, if not decades, of strong profits to arrive at a ratio of 20:1.

Of course, having the government buy into the bank in order to increase equity would increase the budget deficit of Germany by $60 billion (that’s 2% of GDP). Buying into many more banks could increase the deficit by several percentage points. You obviously can’t pursue such a strategy for a very long time, or you end up in default.

Let’s summarize the possible solutions:

a) The government provides fresh equity to banks, i.e. it borrows from future generations to pay for excessive lending of current and past generations. As a result, government debt explodes and we might need strong growth and a little bit more inflation (10% per year) in order to reduce the debt mountain afterwards. The ones who caused this mess won’t face financial consequences.

b) Central banks provide trillions of cheap liquidity, thereby enabling banks to muddle through this crisis and to recover from it during the next 10 or 20 years. A Japanese scenario of low growth and consistent mild deflation. Current and future generations suffer. The ones who caused this mess won’t face financial consequences.

c) We let banks go bankrupt the next time they face huge losses. The economy falters and we go through Great Depression 2.0 for three years. Afterwards, few banks remain, but those will be financially sound and safe. Strong growth should follow, pre-depression income levels should be reached after five years. The ones who caused this mess will face financial consequences. They will suffer as anyone else will during a depression. Future generations will bear almost no costs.

Which solution do you prefer? (I’ll do a poll in my next post)


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