Europe: It's Time For Your Bank Holiday
July 22, 2012
(This item originally appeared on Forbes.com on July 22, 2012.)
Anecdotal reports suggest that the various attempts to shore up
banks’ condition with phony financials and vast theft of public
money are coming to an end. Despite these stopgaps, banks are still
struggling, in many cases taking steps to delay or prevent
withdrawal of funds. This amounts to a sort of soft default, which
may progress soon to a hard default.
“It is increasingly likely that some kind of total ‘bank
holiday’ is enforced to put a stop to market pressures,” wrote
Saxo Bank economist Steen Jakobsen in November 2011. He expected
this to happen
Jakobsen notes that the United States did exactly this in 1933. It
was quite successful, and vastly improved the confidence in the
financial system. This helped the economy to recover during
It seems that many people don’t understand how
banks work, so we will start with a simplified example. The
simplest sort of bank has a balance sheet that looks something like
Assets: $1.0 million of loans (mortgage loans, credit card loans,
corporate loans, etc.)
Liabilities: $900,000 of borrowings (bank deposits, CDs, bonds,
The bank borrows money at a low interest rate, and then lends the
money it borrowed at a higher interest rate.
However, sometimes the bank makes loans to entities that are not
able to pay them back. This is recorded as a decline in asset value.
Borrowers won’t pay back the $1.0 million they borrowed, they will
only pay back $700,000. However, the bank still has to pay back the
$900,000 it borrowed.
The bank is now insolvent. The bank typically borrows on short
maturity. The borrowers can get their money back on short notice.
The bank has to pay the borrowers, but it has no way of doing so.
Nobody will lend the bank money, because its assets are
insufficient. The bank thus defaults on its debts, and is bankrupt.
At this point, what is supposed to happen is this: the bank’s
liabilities are restructured, so that lenders become equity
shareholders. This is a “debt/equity swap.” Afterwards, it looks
The old equity holders get zero, and the former bondholders become
the new equity holders. The bank is solvent again, its liabilities
less than its assets. No public money is required.
The people who loaned the bank $900,000 would find that the
principal value of their loans was reduced to $600,000. However,
they would also become the new owners of the bank. In this case, the
bank has $100,000 of capital (book value), so the market value of
the equity of the now-healthy bank would likely be at least
$100,000. Thus, the lenders would end up with $600,000 of loans to
the bank, and equity worth at least $100,000, for a total of
$700,000. That is a loss from the original $900,000, but not a
particularly disastrous one.
In practice, demand deposits are typically treated as senior to
bondholders and time deposits. The result would be that depositors
would be fully repaid, and bondholders would have a larger portion
of their principal value converted to equity. For example:
Liabilities (before): $500,000 of demand deposits, $400,000 of bonds
and other borrowings.
Liabilities (after): $500,000 of demand deposits, $100,000 of bonds
and other borrowings.
This is what people mean when they say: “bondholders need to take a
haircut.” The bondholders would end up with $100,000 of bonds and
also the equity of the bank, worth at least $100,000.
This process in fact happens quite regularly. In the U.S., the FDIC
has been putting two or three small banks a week through this sort
of balance sheet restructuring.
However, governments have been hesitant to do so for large banks. If
a large bank was restructured, the entities that loaned the bank
money wouldn’t get all their money back. They would get some of it
back, but some would be converted to equity. The process would also
take a little while. Since banks often lend money to each other, and
many large banks today are also fundamentally insolvent, the result
would likely be a sort of chain reaction: if one large bank was
unable to pay its debts, people would assume (correctly) that other
banks will soon be in the same position. Much of the financial
system would be in crisis simultaneously, leading to potential
Thus the “bank holiday.” With government supervision, all banks’
operations are suspended for a short period of time. In 1933, it was
for eight days. During that time, any banks that needed to have
their balance sheets restructured could begin the process. Healthy
banks were allowed to reopen, the public reassured that their bank
was not insolvent. After the systemwide balance sheet restructuring,
all banks would be “healthy,” that is, with liabilities safely below
the value of their assets. They would no longer have to lie about
their financial condition.
Governments have been reluctant to take this step. It would require
vision, understanding, and also a bit of daring to pull the trigger.
However, the other options – thievery of public money, and printing
money at the ECB – are far more destructive, and have effectively
reached their limit. It is no longer so easy to steal public money,
for the simple reason that governments themselves are becoming
unable to borrow. (There is never any need for a “bank bailout,”
although bankers want you to believe otherwise.)
With thievery of public money reaching its end stage, the last
option is aggressive printing of money by the ECB. This could have
potentially disastrous consequences, far worse than a few weeks of
uncertainty as large banks’ balance sheets are restructured.