Why recapitalization is wrong

19 Oct

Recapitalization is the issue of the moment in Europe. It is almost taken for granted that it is the sensible next step. The question is less ‘if’ than ‘how’. Keen to avoid being seen as bailing out bankers, European governments are planning to impose upon Europe’s core banks a deadline of six to nine months after which these banks must have raised their core tier one capital ratio to 9%. In effect, banks are being asked to boost their reserves in order to be better placed to face down whatever losses will come about as part of the resolution to the Eurozone crisis. Predictably, as Patrick Jenkins recounts in his FT column, banks are resisting this move towards higher capital ratios: higher reserves means less lending and less lending means lower profits for the banks. In response, European governments are threatening to undertake recapitalization by force. The banks are upping the ante by saying that if they are forced to recapitalize, they will do so neither via shareholders nor via the state but by shrinking their balance sheets. This will mean a drying up of credit at a time when governments are trying to boost credit within the economy. Faced with this stand off, European governments may call in the banks’ bluff and force them to take state money.

There is something ironic about this round of bail-outs appearing as the victory of governments over the narrow interests of the banking industry. The reality is rather different. What is hidden by this debate about the modalities of recapitalization and the squirming of the banks over higher reserve requirements is the problem of recapitalization itself. We seem to have forgotten why Europe’s banks are in a weak position in the first place. The problem, as Mark Blyth explains very well, is the exposure of banks to the sovereign debt of peripheral Eurozone countries (Greece, Italy, Spain). This exposure is not the result of accident or misfortune. It comes from the determination of banks to make money out of the creation of the Euro. The peculiar features of the Eurozone meant that nations on the periphery were able to benefit from a credit rating identical to Germany’s. However, as Blyth points out, “while core/periphery yields narrowed there was still a spread, and if you were a core bank, you could dump all your boring low-yield German and Dutch debt, load up on periphery debt… and pocket the spread times a few billion exposures”. The banks’ current difficulties are thus the result of the risks they took previously in making profits off the uneven development of the Eurozone economy.

Instead of being recapitalized by governments, which will come with the bitter pill of higher reserve requirements, banks would rather the EU beef up its financial stability mechanism so as to avoid any sovereign defaults within the Eurozone. The alternative, namely recapitalization, still represents a dramatic subsidy from taxpayers to banks as it ensures that these banks are covered for the losses incurred as a result of their lending to peripheral Eurozone economies during the boom years.

These two alternatives – a bigger EFSF or recapitalization – are both significant wealth transfers from taxpayers to the financial sector and should be resisted for that reason. That these are the only two alternatives presently on the table shows how limited and narrow the debate on the current crisis has become.

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2 Responses to “Why recapitalization is wrong”

  1. andrew October 26, 2011 at 2:32 am #

    Thanks for explaining how recapitalization works. I googled recapitalization of banks and there not seem to be a lot of people interested in the topic. The real question is not whether they will do it. My question is, how sustainable is it? will the next crisis be the end?

    great post!

  2. Iakovos Alhadeff May 12, 2014 at 8:46 pm #

    Introduction to Banking Recapitalization

    http://iakal.wordpress.com/2014/05/12/bank-recapitalization/

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