18 May 2011

Fix the Banks to Fix the Crisis

While conventional wisdom says that Europe is embroiled in a debt crisis, I keep pointing out that it is still a financial crisis. The problem is not government debt; it is the solvency of the banks. Fixing the crisis should start with fixing the banks.

Martin Wolf in the FT has a nice illustration of the problem. He shows a chart of the exposure of banks to debt of Greece, Ireland and Portugal. German banks holding such debt  could lose as much as 60% of their capital. France is a little better with exposure worth a bit more than 30%. Even British banks are as risk to around 20% of their capital. Add in Spain and the picture is much worse. German banks' exposure is almost 100% of their capital and French banks have risks up to 60%.

This explains why Eurozone governments are so keen to avoid a default. If soverign debt had to be writen down, bank losses would push them to the brink of bankruptcy, meaning new bail outs. If Greece defaulted on its debt, German banks would need to be rescued by German taxpayers, in effect turning Greek government debt into German government debt.

This also explains why there is now talk of "reprofiling" rather than "restructuring" Greek debt. Which means simply extending the payback period of loans rather than cutting the face value of debt.

The truth almost came out in yesterday's Today programme. A Greek economist explained that the difference is  one of accounting. Reprofiling means that the loan remains unchanged as an asset on a bank's balance sheet. Restructuring forces a bank to regonise the loss and so face up to its solvency problem. ( Adam Shaw jumped in before he could complete the point to press his own view that the language was just "politics".)

Of course, reprofiling doesn't make the banks any more solvent. It just delays the day of reckoning.

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