Monday 21 November 2011

The bank recapitalization law proposal: throwing good money after bad

I had forewarned, on this blog (here and here) and in a 2009 paper that the Portuguese banking system was on route to nationalization.

The current Government has submitted to the Parliament (Assembleia da República) a new law proposal (which revises a prior law) to promote the recapitalization of the banking system with €12bn of public funds. The law proposal has been unanimously approved by the Economics and Public Works Committee. It is to be discussed and voted this week (November 22) by the plenary, a mere 15 days after it was first submitted to the Parliament.

Sadly, the recapitalization option is far more costly than what international best practice would recommend (special resolution regime), and it is poorly implemented. As implied in an interview by its Governor, Carlos Costa, the Bank of Portugal seems to have had a leading role in crafting this law proposal. In various issues (see 1, 2 and 3), the Bank of Portugal sides with the banks, and against the public interest, in an appalling display of regulatory forbearance.

The costs the taxpayers will incur to support the bank recapitalization program are substantial. The Portuguese Government will likely pay an interest rate of 3.5%-4% on the €12bn of loans from the IMF and EFSF that are being used to recapitalize the banking sector.

To put it in context, the interest outlays will likely come to represent around €450 million per year or nearly 50% of the entire 2012 budget allocated to higher education (which in addition to the transfers to public universities and colleges includes financial support to students from low income families). It is as if the government had created an entirely new large entitlement program that does not appear separately in the budget (it will appear under interest expenditure).

In fact, the casual ease with which our policy leaders and legislators dispense with large sums of public funds does not cease to surprise me. It is really a case of cutting costs on the pennies in order splurge on bit item expenditures.

In return for this large outlay of capital, the government gets very little back.

Now, countries like the US, the UK, and Germany had somewhat similar bank recapitalization programs in 2008-2009 and banks received what can only be interpreted as the “glove” treatment. But that was then and those programs generally had far harsher conditions for the banks. Moreover, since then, these countries have put in place much stronger special resolution regime legislation which, for example, in the case of the US Dodd-Frank Act, obliges the government to use an orderly liquidation regime to manage the wind-down of failing large financial institutions (a regime that is much stronger than what I advocate).

In its October 26, 2011 meeting, the European Council agreed to increase bank capital requirements to 9%. But left to national governments significant leeway on how to achieve the capital increase, if additional private sector capital fails to materialize.

Instead, the law proposal under consideration by the Parliament has various deficiencies. Contrary to past international practice, the public interest is not adequately represented in the board, and banks want to reduce the already de minimis representation of the government. This is bound to result in incentives to act against the interest of the largest shareholder (the Government).

Moreover, bank management is not replaced, as occurred, for example, in the case of Sweden, and the UK, and is internationally accepted best practice.

The aim seems to be to avoid political nominations. But, for example, the UK government supported the hiring of a Portuguese (António Horta-Osório) to manage one of its largest (nationalized) banks, the Lloyds Banking Group. The Swedish equally hired foreigners to manage their nationalized banks in their banking crises in the 1990s. So why won’t the Portuguese government replace current managers with foreign managers, for example?

The banks are up in arms because they want to ensure that if share prices recover to earlier levels, the government will not keep the profits. In fact, a recent proposal by the banks, which was also supported by the Bank of Portugal, in essence means that the government gives away to the banks a free and highly valuable 5-year call option to buy the stock back (perhaps even at the original price paid by the government). Depending on the exercise price of the option, it may be worth several billions of euro.

Notwithstanding these details, which are highly detrimental to the public and national interest and much worse than comparable bank recapitalization programs elsewhere in Europe, it is far more likely that the government capital investment in the banks will have to be substantially written down by the Government in a couple of years, i.e., the Government (and the country) will likely suffer large losses on this investment.

In sum, the law proposal should be rejected (though I have little hope of seeing this happening). There are far better and less costly alternatives, namely one based on a special resolution regime. A special resolution regime would ensure a functioning and healthy banking system, at a fraction of the costs. This bank recapitalization law will do neither.

Finally, the IMF staff (together with the remainder of the troika) were in Portugal last week for the 2nd quarterly review of the adjustment program. One would have thought they would have had a hawk-like focus on the law proposal. After all, the €12bn foreseen in it represents in excess of 15% of the entire bailout package. No such luck, unfortunately. IMF staff focused on the trivia.

The IMF staff is making a disservice to clients and to their own institution by condoning this type of policy measure. The IMF staff is not following best practice recommendations (including IMF lessons learned from the Asian crisis and that described in various IMF working papers) and is violating its fiduciary duties towards IMF shareholders, by not being good stewards of the capital the IMF is lending to Portugal and to other European peripheral countries, in this and in other instances.

IMF staff should note that at some point more sensible leadership will arrive at positions of power, who will most certainly dispute the IMF credit so carelessly dispensed. Future leaders will have a fertile ground from which to pick evidence of policy mistakes and responsibility by IMF staff.

Looking further ahead, given this and other mishaps, it seems increasingly unlikely that the IMF will be able to survive the Eurozone sovereign debt crisis. In my view, it will, in a not so distant future, be replaced by some new multilateral institution based in Beijing.


  1. News title in the "Telegraph": "Prepare for riots in euro collapse, Foreign Office warns" -

    Also this week there was an article in the economist appealing to the same issue - "Is this really the end?"

    It seems to me that British politicians are back in bed with the bankers, both in UK and US, trying to "plant" the fear seed to rip huge profits as they are all short in the market. I hope that this attempt of fear contagion does not become a self-fulfilling prophecy.

    It is because of these kind of plays (add to this press "play" the appointment of the Goldman Sachs-PMs in Italy and Greece, our BPN nationalization, etc.) that I am getting increasingly conscious about the power of international and domestic bankers in manipulating my life, my interest payments, and the purchasing power of my salary. These greedy bloodsucking parasites can't get enough! Don't get me wrong. I support efficient financial markets, not bloodsuckers. What we have now is a cartel that dominates the financial arena - probably the results of liberalization that facilitated private monopolies instead of competitive markets. Now I am waiting to see how the Euro zone politicians will fight this back. This brainwashing, fear campaign, is probably the payback for the haircut on Greek debt. Does anyone else has an opinion?

  2. Today:"Central banks act as euro zone crisis rages" -

    "Beautifully" coordinated...

  3. While I agree with the general view on the post, I must say that we are not exactly in the presence of "banksters" who have been playing with taxpayers' money at the Casino and must be punished.
    Hence the very reasonable and balanced proposal, that establishes the conditions for the utilisation of public funds in the pursuit of the european objective of bank capitalisation.
    It's a contingency plan, even if we know it will be fully used by all the banks as they seem to have very few alternatives. And it does provide great latitude for the government to use in a case-by-case basis. The Government CAN impose the line cost on the banks by various forms, even with a profit margin. It CAN be present on the board and CAN replace management, but this only makes sense in cases where the original objectives are not being followed. It wouldn't make sense to immediately punish a bank's board for merely accessing a lifeline facility that aims at helping to achieve an objective that ideally will leave everyone on the system in a safer position. Stronger banks, safer depositors and hopefully a profit on the taxpayers' investment as the value of the shares when we sell our stake can't really be worse than the present one.
    Let's have a little faith in Mr Gaspar.

  4. Maybe there is something else that we are not aware. Something similar to what is going on across the ocean. Bloomberg news: "The Federal Reserve and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. No one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates"



  5. Os bancos têm que mudar muito e ser muito mais prudentes e isso devia ser uma condição para receber apoios e garantias nos seus depósitos.

    Ver as Perguntas e Respostas:
    Acha que o Estado vai a influenciar a gestão [ quem recorrer à linha de recapitalização]?
    Eu gostava que alguém tivesse uma influência de rigor na gestão. Para que os bancos não andassem a financiar compras de acções com base em cauções de obras de arte e outras coisas assim. Houve muitos erros de gestão na banca.

    O argumento é que o Estado não gere bem.
    E a banca, geriu melhor? Além disso, o Estado já teve uma mudança de gestão. Os bancos ainda não tiveram.

    E acha que vão ter?
    Não sei. Da minha experiência de contencioso, sei que o credor não gosta de ver que os devedores a permanecer na fase da negação permanente. Precisa de ver alterações ao comportamento .

    A banca está em negação permanente?
    Ainda vejo alguns comentários contra a recapitalização. Compreendo que não queiram ser diluídos, mas se têm perdas… precisam de ter uma almofada de capital para lhes fazer frente.

    Mariana Abrantes de Sousa,PPP Lusofonia

  6. Buiça,

    thanks for the comments. Allow me to quote John Maynard Keynes ("Consequences to the Banks of a Collapse in Money Values", 1931)

    "A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him."

    Bank managers may have been well intended and may have worked hard and diligently. But the fact is that the market is telling us, with the low bank valuations, that these bank managers failed. They misallocated scarce capital in a very large scale, as also pointed out by António Borges.

    Replacing bank management is not intended as punishment. It is simply common sense. One replaces the management who drove these institutions aground, so one is truly able to learn from mistakes and change course.

    Finally on Victor Gaspar, in my view, the most important contribution he could bring is one of changing processes, changing the way business is done (i.e., improving governance). This would be based in adopting best practices which are used in developed countries. This is what I would have expected from him, given his international experience.

    Unfortunately, this is not what I am seeing in his decisions thus far. These have been characterized by a centralization of power in his person (including in the bank recapitalization law proposal). This, I am afraid, we have seen far too often in the past.