The European Banking Union?

Socializing bank debt is both unjust and will result in a future misallocation of resources. Socialization of bank debt across borders implies that a country’s private borrowing costs are artificially reduced below market rates, as insurance (in the form of credit-default swaps) is provided free of charge by other countries. Thus, capital flows from the core to the periphery would continue to exceed the optimal amount, undermining growth for Europe as a whole.

History offers countless examples of the misallocation of resources that can result from socialization of bank debt. One is the 1980’s savings and loan crisis in the United States, which cost US taxpayers more than $100 billion. Under the umbrella of common deposit insurance, US savings banks made a “gamble for resurrection” – borrowing excessively from their depositors and lending the money out to risky enterprises, knowing that potential profits could be paid out as dividends to shareholders while potential losses would be socialized.

In other words, private profits were generated out of socially wasteful activities. And essentially the same happened with US subprime mortgage lending and with the Spanish banking system in the 2000’s. In both cases, banks took excessive risks in the expectation – eventually vindicated – that governments would bail them out.

Spanish banks speculated on a continuing increase in real-estate prices, which would bring large capital gains to their customers. Indeed, they often lent homeowners more than 100% of the underlying property’s value. To compensate for the damage that their reckless behavior caused, they received €303 billion ($378 billion) in extra credit through Target, the European Central Bank''s interbank payment settlement system, and can now expect a further €100 billion in help from the European Financial Stability Facility. Much of this money will never return.

Debt-equity swaps would be a much better way to recapitalize the banks. Rather than imposing the costs of the ECB’s and EFSF’s losses on European taxpayers, the banks’ creditors could give up some of their claims in exchange for receiving shares from the banks’ owners. Debt-equity swaps rescue the banks without rescuing their shareholders.

Ideally, bank creditors would not lose money, because their fixed-interest claims would be converted into bank shares of similar value. This would be the case as long as the banks’ losses remained smaller than their equity capital. A true loss would be inflicted on a bank’s creditors only if the write-off losses on toxic mortgage loans exceeded the bank’s equity. But, even then, it would be better for creditors to bear the loss than for taxpayers to do so, because this would encourage more cautious lending in the future.

Socializing public debt is already posing a risk to the still-stable eurozone countries. To do the same thing with bank debt could pull hitherto sound economies into the abyss, because bank’s balance sheets are much larger than the volume of government debt. In Spain, the public debt-to-GDP ratio is 69%, but the debt of the Spanish banking system totals 305% of GDP, or about €3.3 trillion – about as much as the combined public debt of all five crisis-stricken eurozone countries.

While the enormous volume of the bank debt implies that governments should shy away from socializing banking risks, it also suggests that only the banks’ creditors could reasonably be asked to foot the bill without being overburdened. Indeed, if, as some believe, only a fraction of the banks’ equity is at risk, the potential debt-equity swaps would be minuscule.

Spanish banks have 7% equity capital on average on their balance sheets. Thus, a debt-equity swap of less than 7.5% of the creditors’ investment would be enough to compensate for the banks’ losses. And, even if the banks’ private depositors, whose claims are 39% of the aggregate balance sheet, were excluded, the debt-equity swap necessary to compensate for a loss of up to 100% of the equity would be less than 12% of the creditors’ investment volume.

Debt-equity swaps have been used successfully in many cases, and they follow from normal bankruptcy procedures. Apart from avoiding the excess burden and injustice of taxation, they also have the benefit of inducing banks’ owners to choose a prudent investment strategy, while persuading creditors to scrutinize and select carefully the banks to which they want to lend.

The care taken in augmenting and preserving the wealth that current generations inherited from their ancestors is the ultimate reason for economic growth and capitalism’s success. Massive government interventions during the crisis have undermined this principle, and have probably already destroyed much of the inherited wealth.

It is time to heed the fundamental laws of economics and put a stop to the imprudence that those charged with fighting the crisis have been allowed to get away with. Europe needs no banking union beyond a common regulatory system.

Hans-Werner Sinn is Professor of Economics at the University of Munich and President of the Ifo Institute for Economic Research

Copyright Project Syndicate 2012