This economist believes we shouldn’t bail out the banks: Let their lenders pay instead

Andrew Lilico
OVER the weekend, the nationalisation of Dexia Belgium was announced, with other parts of Dexia being broken up. On Monday, the nationalisations of a Greek bank (Proton) and a Danish bank (Max) followed. Full-blown Greek default is now imminent, the US and Eurozone economies appear to be in a soft patch, if not yet a double dip, and banking losses (or expected losses) are mounting.

Perhaps it will all blow over. Even if it escalates into a wider crisis, perhaps UK banks will not collapse. But suppose they do – what then? It is surely not politically plausible that the government, having imposed large tax rises and spending cuts, could announce a third major recapitalisation of British banks (following those of late 2008 and early 2009).

I opposed even the first two recapitalisations, believing them immoral and economically destructive. But if the banks go bust again, recapitalisation will also be a failed strategy even in its own misguided terms. Surely after four years of banking crisis it’s time to try something else?

But what? An alternative strategy should aim to mimic what would happen in a well-functioning market. Those that lent their money to failed banks should be the ones that make the losses. The rest of society should not be responsible for the losses of the wealthy. “Losses for lenders!” – that should be our motto.

Two key groups of people lend money to banks. First, depositors; second, bondholders. Bondholders should rank below depositors as claimants on a failed bank. In other words, when a bank goes bust, the bondholders should lose their money before depositors do. A slight variant on this would be for bondholders and large depositors to rank below smaller depositors (say, those below the government’s £85,000 deposit insurance threshold) – this is actually strictly what the Vickers Report recommends.

In a normal business, if it goes bust, it falls into the hands of its creditors – those that have lent it money come to own its assets. That is what should happen to a bank as well. If it goes bust, its bondholders (and perhaps its large depositors) should own it. In practical terms, that means that their loans are converted into shares in the bank.

In this way, the bank gets new capital – new shares – out of its bondholders, instead of the government injecting taxpayer funds (“recapitalisation” – or, not to mince words, partial nationalisation). So the bank isn’t shut down. The depositors can still withdraw their money. The bank carries on making loans. But it has new owners – the former bondholders – and it has fewer debts (because some of its bonds have gone, converted into equity).

Such a debt-equity conversion can be done very quickly – over a weekend, say, or certainly in no more than a fortnight. If it ends up taking any time, then there is the question of how to maintain service to depositors. That can be done by taking a distressed bank into special administration. When a normal company goes bust, it is taken over by administrators. The administrators in the case of banks would be the Bank of England or the Treasury.

When a bank is in special administration, depositors should be able to make withdrawals as usual, if the bank is solvent and has only been placed in administration because it is a bit low on capital. If the bank might be insolvent, then depositors should be able to withdraw 80 per cent of their funds (above the £85,000 deposit insurance threshold). Either way, deposit withdrawals would technically count as borrowings from the government (the government should set up a special deposit access fund – say a trillion pounds in size, funded by newly printed money or quantitative easing bonds – to fund this). If the bank is ultimately liquidated and its assets aren’t sufficient to pay back the government for all deposits withdrawn, then those depositors owe the government a tax liability for the difference.

If, on the other hand, banks are solvent and well-managed but simply have liquidity problems, then the Bank of England should provide unlimited lending to them. This is not a form of bailout. Lending to banks with liquidity problems in a crisis is fundamentally what a central bank is for.

So, if banks are solvent, they should be lent money. If they are insolvent but still viable institutions (they still add value – their operating returns are greater than their costs, before financing costs), they should be recapitalised from their bondholders. If they are unviable, value-destroying entities, then they should be broken up, liquidated. That’s what the market would do. That’s what the government should do now.

No more tax-payer bailouts of the rich by the poor. “Losses for lenders!” – that must be our motto this time.

Andrew Lilico is an economist with Europe Economics and a member of the Shadow Monetary Policy Committee.

Those that lent their money to failed banks should be the ones that end up losing out.