Europe's Triple Threat

There are three basic approaches to resolving the banking crisis (which means resolving the fiscal adjustment, sovereign debt, and euro issues simultaneously). The first approach relies on time, profitability, and eventual workout. One estimate suggests that a 50% reduction in the value of peripheral countries' sovereign debt (reasonable for Greece, but high for the others) would cause about $3 trillion in losses, overwhelming the capital of European banks. But the banks are profitable ongoing enterprises in the current low-interest-rate environment, because they typically engage in short-term borrowing and longer-term lending at higher rates, with leverage. Playing for time thus might enable them gradually to recapitalize themselves by retaining profits or attracting outside capital.

A strong, durable economic recovery would make such an approach workable. Most European officials hope that, when combined with substantial public money to support troubled sovereign debt, it will.
The Obama administration adopted this option, following the unpopular Troubled Asset Relief Program, which injected hundreds of billions of public dollars into the banking system (most of which has been repaid). But some US banks, including Bank of America and Citi, are still vulnerable, with considerable toxic assets (mainly related to home mortgages) on their balance sheets.

The second approach is rapid resolution. But letting questionable banks gradually recapitalize themselves and resolving the bad debt later – perhaps with European Brady Bonds (zero-coupon bonds which in the 1990's enabled US banks and Latin American countries to agree to partial write-downs) – won't work if the losses are too large or the recovery is too fragile. More rapid resolution may be necessary to prevent zombie banks from infecting the financial system.

The US Resolution Trust Corporation rapidly shut down 1,000 insolvent banks and Savings and Loans from 1989 to 1995 so that they would not damage healthy institutions. Scaled to today's economy, assets worth $1.25 trillion were sold off, with 80% of the value recovered. The financial system rapidly returned to health. This approach requires judgment and resolve in separating insolvent institutions from solvent ones.

Finally, there is the path of public capital. If market-driven recapitalization is too slow, and closing failing institutions is impossible, a more extreme alternative is to inject public capital directly into the banks (rather than indirectly, as now, by propping up the value of the sovereign debt that they hold). This approach prevents bank runs, because banks with more capital are safer. But how much public capital should be used, and on what terms? Private capital, of course, is preferable, but, given the risk that it will be wiped out by future public intervention, investors will be wary. In the meantime, regulators are increasing banks' capital ratios.

Europeans, both debtors and creditors, must address the banking problem forthrightly, and simultaneously with the euro, sovereign-debt, and fiscal-adjustment issues. Pretending that banks that passed modest stress tests can be kept open indefinitely with little collateral damage is wishful – and dangerous – thinking.

Michael Boskin, currently Professor of Economics at Stanford University and a senior fellow at the Hoover Institution, was Chairman of President George H. W. Bush's Council of Economic Advisers, 1989-1993.

Copyright: Project Syndicate, 2011.
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