Banks and governments : breaking the deadlock
Banks know two types of investors with an asymmetrical profile: shareholders and depositors (savers). The shareholders provide the solvency with their equity. They are the owners of the companies of which they hope to get dividends from and create capital gains in. But in compensation of the return they hope for, they are the first ones to absorb the losses. Apart from liquidity problems, it is only when the shareholders have lost their entire invested capital that depositors will be negatively impacted and will recover only part of their savings.
At the same time, if the shareholders carry the first losses, they will never have to fill up the liabilities by investing more equity when there is a shortage. That is the principle of a company with limited liability.
Technically speaking, the shareholders bear the first risk of loss in order to protect depositors. As a consequence, banks must have sufficient equity to prevent depositors from being negatively impacted in case of major losses. This equity belonging to the shareholders acts as a shock absorber. The role of prudential regulations like Basel 3 is to improve this.
Since long, academic theorists fear that on average, the global level of equity is insufficient to absorb extreme shocks. This constitutes a systemic risk that could create a malfunction paralyzing the entire financial system.
This explains the role of governments in the rescue of weakened banks. As banks play a central role in the economy and at the same time it is impossible to require shareholders to meet their liabilities, it is the government or a new shareholder's task to provide additional equity. In the recapitalization of Belgian banks, the government has replaced shareholders that were bankrupt by using its own bank loans. Nationalization is thus (in theory) providing an unlimited responsibility to ensure the survival of the bank.
Of course, another phenomenon is taking place in the blind spot of bank bailouts. When the governments will emerge from the banks' capital – which is likely in 3 to 5 years – they will sell their shares back to shareholders (state funds and others). The process will be extremely delicate: new shareholders bringing equity to compensate the return of a limited liability for the shareholder. It will lead to a shareholder dilution, which becomes even more likely if the capital requirements have been raised.
Unfortunately, the problem affecting the sovereign debt introduces a new dimension in the configuration of the banks. In fact these debts have traditionally been exempt from the weighing of equity because they are risk free. In other words, the shareholders of the banks do not have to cover the investment in sovereign debt bonds with equity. It is one of the privileges governments have granted and private shareholders have benefited from the windfall, since they could limit their investment of equity.
The Greek and perhaps Portuguese example makes the assumption of risk free sovereign debt completely invalid. Therefore, it would be logical to see sovereign debts as risky and require equity coverage. Unfortunately, this would come at the expense of private shareholders of banks since their equity would become insufficient. They should then maybe appeal to governments, which are sometimes the same ones of whom the debt became risky. This would lead to a spiral of value destruction and contamination of the ratings.
But at the same time, why should private shareholders absorb a sovereign debt risk, knowing that in case of collapse they will be expropriated by the state that would nationalize the bank to protect the depositors and the functioning of its economy. In extremis, this process would lead to a general bank nationalization that materializes at the rate of state defaults.
That is why things should be approached differently. First of all, banks should be allowed to diversify their activities sufficiently as to reduce their dependency of sovereign debt risk. The generalized come-back to traditional undiversified banks that are too dependent on the state, caries the seeds for annihilation. This diversification is possible without repeating the past.
But that's not all: instead of a nationalisation as final outcome of a bank affected by the sovereign debt risk, a state should refinance trough bonds, the losses of sovereign debts of the same monetary zone, without excessive dilution to shareholders. For us, this approach seems the only one that allows to maintain the banking sector far enough from a tacit nationalization. A strong and stable shareholder structure that is close to the country's economy is now needed for the well-being of the citizens.
To conclude, the difficulties for banks, no matter if they are private or public, will be to restore their solvency and have a stable liquidity. Solvability, or building equity, needs a reduced dividend policy, possible capital increases and asset sales (referred to as deleveraging). The liquidity will in turn be ensured by maintaining a stable deposit base, which leads to campaigns to attract businesses, especially if foreign operators try to capture Belgian savings, which is traditionally very high. This evolution should inevitably lead to a more detailed and more correct pricing of the credits for companies and individuals.
More than ever, banks and governments need to have a constructive dialogue that takes into account the mutual dependence and interests of its citizens. The solution is a tacit agreement between the state and the banks. The banks must commit to funding the state. This part of the contract has already been honoured by the Belgian banks that have significantly increased their amount of Belgian bonds. The state from its side, should allow banks to restore their profitability and diversification of their activities.
