Friday, June 18, 2010

Stress tests and sovereign solvency – part IV in the Edward Hugh tribute series

The Scandinavian banking crisis was solved in the following manner

(a).  The banks were guaranteed

(b).  Someone independent of the banks was invited in to reassess bank capital.

(c).  The banks were then told how much capital they had to raise.  They had a fixed period of time to raise it.

(d).  If they could raise it – well and good – and they kept operating.  If they could not the Government injected capital cancelling existing equity as it went and where it could ultimately wind up with 100 percent ownership.  They were not afraid of the “n-word” (ie nationalisation).

The American solution worked almost identically except for step (d).  In America

(a).  The government told us that there would be “no more Lehmans” and they kept telling us and giving banks access to additional funds until we all knew the banks were effectively guaranteed,

(b).  They had a “stress test” to assess how much capital to raise.

(c).  The banks were told how much capital to raise and given a time.  They raised it in common equity.

(d).  If the banks could not raise the capital the government injected capital as common shares until they had enough.  Note that the US process could not wind up with 100 percent ownership of a bank – and the “n-word” was not used.  If the US had run on the Scandianvian formula Citigroup would be entirely government property. 

That said – the end solution in America and Scandinavia were remarkably similar – it was just that the language around them was different.  The “n-word” – which Americans are scared of and Scandinavians are not was the key difference.

This solution works provided you have sovereign solvency.  A sovereign can do this if it can print money (I will go into mechanics later) but cannot do it on a gold-standard or Euro standard.  The Scandinavians needed to de-peg their currency from Europe to achieve their solution and to this day there is a Swedish, Norwegian and Danish Kroner.  Finland alone took up the Euro – but Finland has no large domestically owned banks. 

The solution will work in Europe too provided the currency of the PIGS is separated from the Euro.  It will not work otherwise because step (a) above – the Government guarantee of the banks – is not possible.

Mr Geithner is encouraging Europe to run stress tests – because they worked so well in America.  That is fine – but it is only fine if you also run sovereign stress tests.  A guarantee is a necessary part of this solution – and that guarantee means that the real stress is on the sovereign not on the bank.

Scandinavia found that out.  The classic Norges Bank book on the crisis makes it absolutely clear that delinking the currency was the key to the solution.  And so it will be again.  The stress tests done in a vacuum mean nothing.






狂猪 said...


I agreed bank solvency depends on sovereign solvency. This is particularly true for banks like NBG with their significant Greek bond holding.

However, there are multiple ways to achieve sovereign solvency - at least in the short and medium term (time horizon is important).

1. own the printing press
2. sovereign bail out from euro zone, ECB and IMF
3. growth - listed here only for completeness

The Greece bail out package guarantees Greece funding needs for the next 3 year. The separate $1 trillion dollar package guarantees funding needs for the other Mediterranean states. From a practical point of view, the questions are:

1. Can the market force Greece, Portugal, Spain, etc. into sovereign default?

With the bailout packages in place, these countries will be able to meet all their obligations. I maybe wrong, but I don't see how the market can force these countries into sovereign default.

2. Will Greece, Portugal, Spain, etc. purposely choose sovereign default in the near term?

Within the next 3 years, I think this is very unlikely. This is because it will hurt Greece, Portugal, Spain, etc more economically if they default. If they default, all their excess fiscal spending must come to an immediate halt. Furthermore, their banking system will collapse. Can the economic benefit of sovereign default really out weight that level of calamity?

Ultimately, my main concern is not whether Greece defaults. My main concern is contagion. Therefore, I think time is very valuable. I don't know if Greece will default after 3 years. However, I do believe Greece defaulting after 3 years is much better than Greece defaulting tomorrow. In time, the world economy will be healthier. Also, institutions will have taking steps to better manage contagion risk.

Having said the above, I think we should add the following step before (a) in John's list of steps to solving banking crisis.

(0) euro zone, ECB, IMF told us sovereign solvency is guaranteed for the next 3 years. Is it correct to say this is ultimately back by the euro printing press and therefore credible?

With this step (0), I think the stress test is meaningful. For example, I am bothered by the market punishing Spanish bank funding indiscriminately. That punishes Spain more than it deserved.

What I am really uncertain about is the bank funding situation for Greece, Spain, and others for the next 3 years. Any thoughts on how that dynamic will play out?

Also, John, since you don't seem to agree with my view, when do you think a sovereign default will likely happen?

Charles Butler said...


The problem with this tack is that, for all the logical sense it might make, it is very unlikely that the late arrivals to the euro leave the EMU. 'High probability long tail' is an oxymoron. The more likely response to the possibility of sovereign defaults within the zone will be a typically clumsy, crisis-by-crisis redefinition of the place of individual states within the EMU itself.


A large portion of the bank funding problem in Spain resides in the cajas. The fundamental problem they have is that they legally can't raise money through equity sales and have to rely on deposits, covered bonds and various silly interest-bearing things they foist on the widows and orphans among their clientele. The covered is the only item of interest to institutional investors. For all they might currently be undesirable pieces of paper, most of the cajas are probably at the Spanish legal limit regarding their issuance anyway. The only paper that wants to come to market is that which needs to be rolled. the seriousness of this various from institution to institution.

On the other hand, a very thorough consolidation of the sector is taking place under the SIP framework, rather than through outright mergers. The parent company of these new entities is, legally, a bank. The door has been opened to equity participation. Between recurring crises and the passage of time, the ideologues and self-interested that resist even the partial privatization of the cajas will find themselves defeated.


babar ganesh said...

how can the US have a strong recovery if the eurozone and asia are exporting deflation?

Anonymous said...

Would it not be smarter to decouple the strong countries from the Euro instead of the Club Med. Since the debt burdens are nominated in Euro and a spin off by the southern countries would inevatably lead to their insolvency. The other way around would also be painful but the appreciation of the "northern new Euro", were helpful for the exports of the south and the debt restructuring could take more time.

Anonymous said...

Certainly in Sweden, the decision to stop defending the kronor and allow it to devalue in Nov. 1992 (it ended up devaluing about 30% against the ecu) was perhaps the most critical element in rescuing the banks during that crisis by quickly returning the country on a path to growth.

Sitting hear in the Baltics today, i see the same swedish banks parking loads of still overvalued assets into restructuring vehicles and waiting for growth to return to bail them out as in the early 1990's.

Alas, it is not clear that there will be an upturn in Europe as in 1993 nor have the Baltics prices declined enough for the countries to regain competitiveness.

Unknown said...

Hey John,

Is it stealing when you give credit?


General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.