But before we declare victory, we need to be clear that the real battle lies ahead. Over the next four decades, the government will be under unrelenting pressure to finance the commitments of the developed world governments and pay interest on its accumulated debt.
Even if the political miracle of balanced budgets were adopted (along with ultra-pro-growth policies), that wouldn’t eliminate the interest expense on the debt that has already been accumulated. Governments will need to marshal the political will shortly, if it’s not already too late.
If they don’t, what lies ahead are more Cyprus-type events in which bank deposit cram-down is, in effect, a tax on private wealth — the result of government pressures to sell debt.
Here’s how this occurs: Governments delude themselves and their constituencies to think there is no sovereign debt finance problem and hence no need to stop spending. A favorite tactic in this self-delusion has been to force-feed government debt onto the balance sheets of the country’s private banks and non-bank financial institutions.
Within the EU, that tactic went pan-European. This means Greek debt (remember that?) is sprinkled onto the balance sheets of institutions across Europe — especially the Cyprus banks, as it turned out. Financial regulation encourages this sprinkling of debt by declaring government debt to be safe and sound, pushing private institutions to expose themselves to government debt risk.
This is typically done before governments turn to their central banks to support their bonds, an outcome that has only occurred recently.
Basically, the regulated financial institutions were made into piggy banks to finance their government’s deficits and allow them to keep on spending. In piggybanks economics, governments pilfer the funds and leave a confessional note, which in this case are their government’s bonds. After all, who would criticize the banks for being a party to the pilfering when the government’s debt is classified by regulators and rating agencies to be Tier 1, or riskless?
This is not a solution — it is merely an enabling device that allows the government to avoid short-term pain and financial embarrassment from not being able to sell their bonds to market investors at reasonably low yields. But it builds on itself and blossoms into later and greater pain.
It’s an attempt to cure cancer with aspirin, covering up the underlying financing discomfort of the government debt overload. But with the advance of time, the aspirin has worn off and the cancer has spread. It took down the banks in Cyprus, which had purchased a large helping of Greek government debt that subsequently took a 74% haircut.
To add to the government’s financial problems, piggybank finance in turn triggers deposit insurance payouts, typically by the same government whose bonds were written down. When government bonds depreciate due to market risk valuations, there is a multiplier effect on fiscal demands, accelerating the decline and fall of both governments and banks.
Since European governments only recently took up pan-European bank supervision and joint responsibility for bank losses, it was too late to prevent the crisis in Cyprus, as there was no time to build up a deposit insurance trust fund. That requires many years of banks paying a deposit insurance fee that actually goes into a lock box, so bank bailout assistance needed to be pay- as-you-go.
When the German and Dutch voters contracted a well-deserved case of assistance fatigue for southern European banks, this ushered in the era of private wealth meltdown in the form of depositor haircuts.
In the words of the Dutch finance minister, what you just saw in Cyprus is the template for future insolvent banks. In an interview with reporters in Brussels after the Cyprus plan, he indicated:
“What we’ve done last night is what I call pushing back the risks (onto depositors).…If we want to have a healthy, sound financial sector, the only way is to say, Look, where you (depositors) take on the risks, you must deal with them, and if you can’t deal with them, then you shouldn’t have taken them on … that is an approach that I think … now we should take.”
What has abruptly occurred is a shifting of the burden and responsibility to the private wealth owner, and an end to the pretense of government responsibility for financial stability, safety and soundness.
This is the end of the post-Depression era in practice since the bank runs of the 1930s, in which governments sought to preserve, protect and defend private wealth owners — and had some ability to do so.
Heretofore in the saga of Euro sovereign financial strains (now in its fourth year), all revisions and reinterpretations of the underlying treaties, laws, collateral agreements, benchmarks, and other policies that formed an understanding of the rule of law were protective of the individual in times of extreme stress. That is, hastily assembled Euro country bailout funds and the ECB’s extraordinary LTRO financing of banks and its support of various government bonds was in violation the rules but for the benefit of private wealth owners.
This has been replaced by reinterpreting the rule of law to benefit governments at the expense of private wealth owners, pushing depositors to the front of the line to take losses in order to protect the government.
This is a tectonic shift. It raises questions about the future costs and changes that could stem from the loss of confidence in government protection of wealth, especially among bank depositors.
This loss of confidence will drive risk premiums on bank deposits of both insured and uninsured deposits. This natural financing response by depositors implies a higher deposit rate commensurate with the perceived risks before depositing, resulting in shrinkage in banks’ spreads between the yields earned on assets and paid for funding.
As it happens I was involved, along with co-author Doug Cook, in a study of the size of the risk premiums depositors required when confidence in deposit insurance protection was in question in the U.S. during the Savings and Loan crisis of the 1980s. Even with deposit insurance pledges by the government (but with a yet to be recapitalized deposit insurance fund), the market assessed on average 370 basis points to the bank’s cost of funding due to the insurance risk (as apart from the bank’s risk) in the geographic areas where it was thought the banks’ assets were weak.
This represents an enormous shrinkage of the banks’ underlying profitability even in the absence of further asset write-downs. And moreover, banks have become especially vulnerable when central banks drive down asset yields to a floor of zero and the market forces its funding costs upward. There is no margin left in the middle, which is a banking disaster in the making.
To give you an idea of where we may be heading, the net impact of government guarantee risk on the U.S. Savings and Loan industry is that the industry no longer exists. This raises the question of where Euro banking will migrate, as there is a large demand for riskless transaction assets.
No doubt some Euro bank funding will find the U.S. shores, but the same underlying softness exists in U.S. deposit insurance guarantees, as the FDIC is barely solvent and the U.S. government is central-bank dependent. Hence, the U.S. suffers from the same cancer, albeit at an earlier stage.
The Cyprus fiasco was well more than a reorganization for the Bank of Cyprus. It is a revelation that developed-world banking is not anchored on terra firma for those with claims on the piggy banks, whether they are bank deposits, annuities or private pension funds. They are all at risk now and are no longer government supportable.
The bottom line, as stated by the Dutch Finance Minister, is that investors now need to examine carefully their chosen private financial institution’s balance sheets and their wealth holdings with a new understanding of risk in this new millenium.
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