How to rescue your banker, whether you like it or not

How to rescue your banker, whether you like it or not

Which would you rather? A bank bailout or a bank bail-in?

If you ever hear a politician utter those words at a press conference, I think you should bail on the banking system altogether.

Do a runner with your money. Get out of the banking system with a big chunk of your wealth. As much as possible. Before you discover what it all means the hard way.

But where to?

Well, when it comes to securing my own money, I’m trying to buy a house.

I’d rather owe the bank money than have deposits there in a crisis. But that’s just a start.

Today, I’m going to explain the meaning of those two bails I mentioned.

The bail-in and the bailout of banks.

Because a tectonic shift took place in the European banking system in 2013. And a similar shift took place in the Aussie banking system in 2017.

It has changed the way banks will fail in the future.

Well, it might. The Italian government already proved that making these laws and sticking to them are two different things. But if a big crisis strikes, you need to know how it will unfold.

The difference between a bailout and a bail-in

Bailouts use government money to make a bank whole again. By giving the bank taxpayer money, the bank can re-establish the capital reserves it needs to function. To be trustworthy.

But bailouts aren’t very popular politically. Using taxpayer money to rescue wealthy bankers from their own bad lending decisions doesn’t buy many votes.

In 2012, the cost of bailouts also threatened to bankrupt entire European nations…which isn’t a winning political strategy either.

So, where should the money to rescue banks come from? I’m sure you can guess where this is going…

Inspired by the partial success of the policy in Cyprus in 2013, governments have turned to the idea of bank bail-ins. This is where money is taken from people the bank owes money to, and given to the bank.

The question is, who and how? Whose money is taken, and how is it given to the bank to re-establish the capital reserves?

Europe, Britain and Australia have answered those questions slightly differently. But we won’t go into that level of detail today. Because governments and bankers never stick to their own rules completely anyway.

Instead, realise the general gist of what’s changed. The government now plans to use your money to help rescue a bank that fails.

Not your money as a taxpayer. Your money as a depositor and investor.

And when I say ‘plans’, I mean they’ve already made the laws that take your money and use it to rescue your bank when it fails. In Australia, that law was passed in 2018.

So let’s see what the government has planned for you.

Bank robbery…reversed

In an attempt to prepare for the last financial crisis, different countries are trying different mixes of bailout and bail-in schemes. 2008 caught governments embarrassingly unprepared. So the rules for rescuing banks in the next crisis must be ready to go beforehand.

The chart below shows the underlying nature of the problem banks face. Why do you care about it? Because, when the government takes money out of your bank account to help your banker keep his job, you’ll know why they did it…  

And once you see what’s coming, you’ll have the rest of your money safely stashed elsewhere.

Let’s start on the left-hand side of the chart — ‘bank before failure’.

As you can see, the bank has made lots of loans. These are in pink. Some of the loans are good, some are polka dot bad.

Loans are the assets of the bank. Because people owe the money to the bank, the loans are something of value the bank owns.

Next to the pink assets, you have three different categories in white. Up top are the banks’ debts. Depositors’ money is the bank’s debt because the bank owes this money to depositors.

It’s strange, I know. Debts are assets to a bank. And your assets are their debts, because you could ask for them back at any point. The trick is to see it all from the perspective of the bank. Loans are their assets because people owe the bank. Deposits are debts because the bank owes customers.

Below deposits, things get confusing. Ignore the ‘loss-absorbing debt’ for the moment. Then there is the equity, which is similar to the equity in your home. It’s the shareholders’ stake in the bank. The owners’ capital.

We’re operating in the dual world of accounting and finance here. On the one hand, the shareholders’ stake is valued in the stock market. On the other hand, it also has an accounting value, as depicted in the chart. Juggling the two is part of what makes banking so confusing. But we’ll keep things simple here.

So, back to the chart.

The moving parts expose the risk to you

Imagine a world where many of the banks’ loans go bad. (Or read the Aussie news.) Customers stop repaying their debt. This reduces the value of the bank’s assets — the loans. The pink bar shrinks. We’re now in the centre of the chart — the ‘write-down process’.

Under the accounting system in use since the Medici family invented it, the two sides — the pink and white — have to balance. How does this work? When a bank does well, the value of assets rises and the value of the equity rises too. Shares in the bank rise in value and usually rise in price on the stock market.

What happens when the value of assets falls because the loans sour? The value of the equity falls. After all, it’s not like the bank owes its depositors less as loans go bad. It’s the owners of the bank who lose money. It’s like when house prices fall. The value of your equity stake falls. The value of your mortgage doesn’t.

When the value of the shareholders’ claim goes down, the value of shares on the stock market go down. That’s the history of the European banking sector for the last few years.

The trouble is, if a bank’s equity goes negative, it creates a big problem. The bank can fail and the whole financial system can implode. Lehman Brothers displayed that nicely.

To avoid this, governments give the banks more money. But there are all sorts of ways to do this. You can bail them out with more equity, which is how the UK government came to own a lot of the UK’s banks. Or you can lend to them, as the European Central Bank does today. Or you can buy the bad loans off them, as they did in Ireland.

In Europe, the cost of these solutions ended up sending entire governments broke. And so the regulators have come up with a different idea. A way to make someone else pay for the cost of bailing out banks.

If you want to know who, take a look in the mirror.

Regulators and politicians around the world have created a new category on banks’ balance sheets — as the chart above shows. It’s called ‘loss-absorbing debt’. A form of bail-in.

The idea here is to create a buffer. It’s a bit like the crumple zone of your car. The front of your car seems pretty solid. But in a head-on collision, it’s designed to crumple and thereby soften the impact, protecting you.

Unfortunately, when it comes to bank bail-ins, the crumple zone is you.

Who benefits, who pays?

Loss-absorbing debt is money the bank has borrowed. It lends that borrowed money out as loans to customers. The difference between the interest it borrowed at and the interest it lent at is the profit margin of the bank.

But loss-absorbing debt is designed to crumple if something goes wrong. If enough loans go bad, the loss-absorbing debt converts into something else. Usually shares — the ones listed on the stock exchange.

And that’s what the three parts of the chart above are trying to show you. When the pink bar — the assets — falls far enough to wipe out the equity, then the loss-absorbing debt is converted to new equity. We’re now in the right-hand side of the chart — ‘bank after bail-in’.

After the bail-in, the people who lent to the bank now own shares in it instead. This rebalances the bank into having sufficient equity (capital) again. And it owes less money.

The process turns money the bank owed to people into shares of ownership in the bank. The previous owners? Bank shareholders like you? They no longer own anything. Wiped out. Gone. By government edict.

The question is, what is this loss-absorbing debt? And does it include your deposits?

The liability cascade flows right through your bank account

Bail-ins sound like a pretty good plan. The people who lend money to a bad bank shouldn’t just be rescued by the government. They should bear some of the losses.

The trouble is, depositors are lenders to the bank too. And sometimes, they can be dragged into the bail-in. The government can decide that your savings at the bank are a form of ‘loss-absorbing debt’, too. Academics call this the liability cascade.

None of this is abstract. It’s the law. In the UK, EU and Australia. And it played out in Cyprus, Spain and Italy. Cyprus is the best example.

The largest bank in the country converted 37.5% of deposits exceeding €100,000 into shares. 22.5% more were held ready to be converted if needed. And another 30% were frozen to prevent people from withdrawing the money.

In other words, the bank no longer owed depositors the money. They’d become shareholders instead. Imagine opening that letter…a notification of shares you now own instead of the bank statement you expected.

Now, you might take a look at that €100,000 (AU$158,000) and decide none of this matters to you. In Australia, the limit is even higher — $250,000.

But I beg to differ.

In a world where investment prices are crashing, the obvious thing to do is sell out. My point today is that you aren’t safer in cash than in the investments you are selling.

That’s the conclusion I want you to take to the…well, not the bank.

Humour aside, this gets very real.

One British woman in Cyprus sold her house there at the height of the crisis. She had more than the €100,000 in her account as a result. And got caught up in the mess.

If you want to avoid a financial crisis, you can’t flee into the banking system. It’ll be out of the pan and into the fire. Simply selling your investments doesn’t work if you want to protect your wealth from a crash.

You don’t plug your backup generator into the mains.

The whole point of a backup generator is that it isn’t part of the system that can fail.

Well, selling your investments for cash in a bank account would be making this very mistake.

But could Aussie banks really fail? Of course! They had to be rescued by the American central bank in 2008.

And the Aussie subprime bubble just popped…

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia