Implications Of Eurozone Depositor Discipline For Cash Management

It is the explicit intention of the Eurogroup* to implement a new bank resolution regime for the EU that is intended to eliminate bank bailouts (TBTF). It provides that banks will be resolved at the expense of shareholders, bondholders and, if necessary, uninsured depositors. Consequently, wealthy individuals, businesses and fiduciaries will be expected to discriminate between good and bad depositories. This is an ill-advised public policy choice.

Under the new dispensation, eurozone depositors can handle this challenge in one of two ways: (1) the identification of banks likely to fail; or (2) the identification of banks which are likely to still be TBTF despite the new policy.

Is it possible to identify banks likely to fail? Yes, one can easily make up a list of troubled banks, that is, banks which have already reported problems in their financials, e.g.,  Banca MPS, Commerzbank, Credit Foncier, Deutsche Pfandbrief, Bankia, etc. But what about banks that may be at risk of failure but which have not yet reported problems in their financial disclosure? Identifying these banks is more difficult, but not impossible which is why rating agencies and other bank credit analysts exist: to spot and flag the weak and the aged.

But if one could identify the banks that would never be allowed to default on their deposits, wouldn't that be a lot easier than looking for creditworthy banks? It doesn’t take a an astrophysicist to answer the question: what are the names of the biggest banks in the strongest countries in Europe? These banks, no matter how awful, will always be TBTF, because they are important and their governments can afford to bail them out. Frankly, I’d prefer to be exposed to a small bank in the North than a big bank in the South. Uninsured depositors at Deutsche Bank and its Northern peers will always be protected no matter what happens in terms of solvency.

The US has had a two-tiered bank resolution regime for forty years (since Franklin National in 1974). Small banks are allowed to default, while big banks (now called Sifis**) are rescued at the expense of the FDIC, plus shareholders and holding company creditors. Uninsured depositors of big banks have always been protected. (Note: WAMU was not a Sifi.)  

Since the 1980s, Congress has passed a slew of laws seeking to minimize bailouts without creating financial instability, most recently Dodd-Frank. Dodd-Frank permits*** bailouts of Sifis, to the consternation of the Wall Street-haters.

In the US, institutional depositors know that they should avoid having large uninsured deposits in banks that are not Sifis. IBM’s treasury function is not going to concentrate its global cash management at the Citizen's Bank of Armonk.

However, depositor discipline will come a novelty to European corporate treasurers, especially those domiciled in Club Med. If your government may not be able to rescue its banks, you will need to find a safe place to keep your euros: a big bank from a strong country. But it is not clear that this would include such a bank's branches in your country. There is certainly a risk that, if your country imposes exchange controls or redenominates, deposits at domestic branches of foreign banks will be caught up by that law. (My understanding is that, in Cyprus, deposits in domestic branches of foreign banks were not confiscated, but they have been subjected to the "temporary" exchange controls.)

This suggests that the prudent institutional depositor in a Club Med country will have to keep his deposits at a large foreign bank at a branch outside the jurisdiction of his government. So, for example, a large Portuguese insurance company will want to keep its euros on deposit in a big German bank at a branch outside of Portugal. This is do-able, and shouldn't overly inconvenience the large Portuguese insurance company.

But what about the Portuguese bank that currently has these deposits? Won't it be a problem for that bank to lose its institutional depositors? What can the Portuguese government say to depositors to reassure them that it will have the resources to maintain the solvency of the banking system? It seems to me that this would lead the Portuguese government to preemptively and decisively recapitalize all of its banks in order to ensure that there could be no question of their solvency. But, in point of fact,  I don't think that the Portuguese government has the money to do that, nor do I think that Spain or Italy have the money either.

This is in part because, the more that a government incurs debt to recapitalize its banks, the more likely it is that its debt ratio (D/GDP) will cross the IMF's red line. Once that red line is crossed, the IMF (hence, the troika) won't lend. In that case, the country must haircut its bondholders or its depositors to bring its debt below the red line.

The knowledge that eurozone bailouts are conditional encourages bondholders and depositors to lower their risk limits for Club Med. This is happening at risk committees around the world. If your bank has $10B in exposure to Portugal and a $5B risk limit, that exposure will have to come down. Consequently, private-sector bank deposits and other credit exposures for Club Med will decline, with implications for both bank liquidity and monetary policy.

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*Eurogroup: the committee of the finance ministers of the eurozone. The unit that runs the eurozone. Headed by Dutch finance minister Jeroen Dijisselbloem, who advocates “bailing in” uninsured depositors because they are “investors”.

**Sifi: "systemically-important financial institution", i.e., TBTF.

***We owe this important safeguard to Rep. Barney Frank, who deserves a monument in the Financial Stability Hall of Fame. Replacing Barney Frank, an informed intellectual, as chair of the House Banking Committee, with Rep. Maxine Waters was truly unfortunate. Personalities matter in financial crises; everyone respected Barney, and for good reason. There would have been no TARP if it weren’t for him and Nancy Pelosi.