The ongoing worries of another financial crisis, perhaps induced by a European sovereign default, center on the role of bank solvency. If the financial system experiences another systemic default, banks will take large losses, and some may be forced to raise capital. To deal with the ensuing bank runs and fear, governments may well step in to bail out bankers. Even if nothing worse happens, taxpayers may well be on the hook for large amounts of money lost at major financial institutions.
To deal with this problem, e21 has long favored bail-in strategies that first aim to fill capital gaps with the equity and bondholders of financial firms. Institutions earning a risk premium for lending to financial firms ought to actually bear that risk when times turn bad ahead of taxpayers.
John Hussman in his weekly commentary makes a related point:
Now take a look at Citigroup's balance sheet. Reported assets are $1.956 trillion. Against that, liabilities to depositors again amount to less than half of that, at $866 billion. Add in $204 billion in repurchase obligations, $209 billion in trading and brokerage liabilities, and $73 billion in other liabilities, and you're still only up to $1.352 trillion. The remaining 31% of Citigroup's liabilities, again, represent obligations to its own bondholders and equity of its own shareholders. And again, to say that Citigroup can't be allowed to "fail" is really simply to say that Citigroup's bondholders can't be allowed to experience a loss.
You can do the same calculations for nearly every major financial institution in the world. The amount of bondholders and equity coverage varies somewhat, but in virtually every case, bondholder and shareholder capital of these institutions are more than sufficient to absorb any losses without the need for public funds, provided that the objective of government policy is to protect the people and the long-term viability of the economy, rather than defending the existing owners, bondholders, and managements of these institutions. Make no mistake - that choice is what the oncoming crisis is going to be about. [emphasis added]
To be sure, there is an ongoing debate over whether current capital requirements will prove sufficient in a future financial crisis. Yet Title 2 of the Dodd-Frank Bill already empowers the Treasury to take over failing financial firms, and for the government to provide interim financing. This may well pave the way for way for large transfers of taxpayer funds to financial firms; which both deprives the public treasury of essential revenue, along with fueling moral hazard in financial markets.
As Hussman notes, a better and more feasible alternative would be to look first at current creditors. While shareholders typically face losses in the event of bank failure, many bondholders fully recouped their investment during the 2008 financial crisis due to government bailouts. Worries of “contagion” or “systemic risk” ought not blind regulators to the fact that the lenders to financial firms must bear losses ahead of taxpayers. That’s the only equitable and law-based approach to handling financial firm bankruptcy.
Elsewhere, Hussmain argues against leveraging the EFSF, a point that e21 has echoed in the past as well:
The bottom line is this. It is misguided to believe that Europe can save Greece from defaultand also contain contagion from Europe's other distressed countries. If Greece is included in the ring-fence, then even if we assume a worst-case recovery rate of 90% on distressednon-Greek European debt, the maximum leverage of the EFSF would still only be 2-to-1. The idea of 7-to-1 or 10-to-1 leverage is a pipe dream that assumes the ECB will be complicit in destroying the euro through currency creation.
Hussman argues that the price of paying off Greece to not default would bankrupt the “core” countries and simply shift financial worries to the stability of an over-levered bailout fund. He concludes that a peripheral default is the only real solution to the problem.
Hussman’s piece is well worth reading in its entirety. One is left with the conclusion that we have not left financial crisis-style troubles behind, and canny actions from policymakers will be necessary to avoid further turmoil and taxpayer losses. Unfortunately, this does not seem to be forthcoming.