The question facing Europe’s policymakers is who eats the loss.
The French and Belgian governments offer clues with the troubled bank Dexia.
Dexia’s exposure to Greek sovereign debt and residual problems from the financial crisis mean that the Brussels-based giant is in trouble again. Both governments have said they’ll backstop the bank; depositors and creditors will be safeguarded.
It’s an open question how equity holders will fare, however, given talk of a break-up and nationalization of parts.
Both governments dismiss the implications to their own credit ratings; Ireland’s example notwithstanding. They may be a bit complacent. Dexia’s assets represent more than one and a half times the Belgian economy’s annual output and more than a third of France’s. And should Dexia’s problems not prove to be unique, the precedent France and Belgium have set means that they’ll be forced to defend the whole of their banking sectors on the same terms. Which is to say a promise to make their bank bondholders whole.
This is an enormous mistake.
John Hussman of Hussman Funds has long argued this from the perspective of U.S. banks, but it applies equally to European institutions. In all except the most extreme cases, banks have enough shareholder and bondholder capital to make good on losses derived from the financial crisis and the European sovereign-debt crisis without in the least impinging on depositor funds.
But this requires that shareholders and bondholders take losses.
Given that they get paid a risk premium for holding these assets, presumably they know there’s potential downside too. Governments don’t see it that way. By protecting bondholders against any losses they force them on taxpayers instead. It is a prime example of privatized profits and socialized losses and one that will lead increasingly to popular unrest of the sort now sweeping Greece.
Governments are afraid of what damage losses to their financial systems might cause their wider economies, given the importance of credit in how they function. But the iniquity of defending one relatively narrow and typically wealthy set of interests at the cost of social fairness could yet rebound on them. Ultimately, the damage caused by defending their banks could well prove greater than the damage caused by allowing them to fail.