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.
John