The Dijssel-Bomb

Eric Sprott and David Franklin

 This past March, Jeroen Dijsselbloem, the head of the finance ministers of the eurozone, shocked the markets with seemingly off-the-cuff comments suggesting that the Cyprus banking solution will, “serve as a model for dealing with future banking crises.”¹ Depositors across Europe took a collective gasp of horror – could banks possibly confiscate depositors’ funds in a form of daylight robbery? Indeed they could, and last week the Bank for International Settlements (“BIS”), the Central Bank's Central Bank, published what we have referred to as ‘the template’; a blueprint outlining the steps to handle the failure of a major bank and the conditions to be met before ‘bailing-in’ deposits. 

In their recently published paper “A Template For Recapitalising Too-Big-To-Fail Banks”, authors Paul Melaschenko and Noel Reynolds argue for a “simple” mechanism to recapitalize failed banks without the use of taxpayers' money. They propose a process whereby a bank, if it reached the point of failure, could transfer ownership to a newly created holding company over a weekend and be recapitalized. The bank would then be sold, enabling the market to determine the ultimate losses to previous equity holders and creditors. And, yes, this scenario includes losses for depositors above a guaranteed limit. Presto! A new bank with a clean balance sheet, ready to receive liquidity support from the prevailing central bank, without the need for handouts, bailouts, TARP programs, or any other form of government assistance. Previous debt and equity holders and depositors of this failed bank would be left with an equity position in the new entity. This ‘template’ would ensure that “shareholders and uninsured private sector creditors (read: depositors and bond holders) of such banks, rather than taxpayers, bear the cost of resolution.”² While at the moment this framework is only outlined in a discussion paper, it confirms our suspicions. While the old template involved “bailing out” banks through the transfer of toxic assets from the corporate sector to the taxpayer, the new template calls for “bailing in”. In this model the risk is contained within the affected institution at the expense of equity holders, bond holders and finally depositors. Far from being an idle comment, the unscripted 'bomb' that Mr. Dijsselbloem dropped on the market during the Cyprus Banking crisis is on its way to becoming a reality across Europe and other major banking centers.

In our opinion, the problem with the banks stems from an over-levered banking system that still has not been brought under control. Traditionally, banks would “de-lever” by selling portions of their loan portfolios to other banks, but since 2008, this hasn’t happened in most instances and leverage has remained elevated. In fact, an example of a bank “bail-out” that highlights the over-leverage still plaguing the system, happened recently in Mr. Dijsselbloem’s own back-yard. In this instance, the Netherlands nationalized SNS Reaal, a banking and insurance group, in a $14 billion rescue that highlights the continued fragility of the European banking sector.

From The Wall Street Journal:

The government rescue was inevitable after SNS Reaal suffered a run on deposits and failed to raise capital on its own. “It is worrisome. Nearly the entire Dutch banking system is now on a government lifeline,” said Arnoud Boot, a professor of corporate finance at the University of Amsterdam. The Dutch state will inject €2.2 billion ($2.99 billion) into the company, write off €800 million from an earlier bailout and €700 million on the value of SNS Reaal's toxic property loans. It will also provide an additional €6.1 billion in loans and guarantees to put the firm on a sound footing. The burden to taxpayers will be eased somewhat through a €1 billion contribution from the other Dutch banks through a special levy.³

Can you see the pattern? Depositor runs triggered a bailout of an over-levered institution, leading to a write-off of toxic assets, additional lending and guarantees by the government. All of this committed to by Mr. Dijsselbloem on behalf of the Dutch people. This will likely be the last time we see a rescue in this fashion, for now we have a new ‘template’ whose prima facie case was Cyprus. It is interesting to note that, to the best of our knowledge, there was no discussion of “bail-ins” for Dutch depositors of SNS Reaal.

It is clear now that the crossing of the Rubicon into the confiscation of depositor funds was not a one-off emergency measure limited to Cyprus. We can only speculate as to what triggered these new rules. Perhaps the public would no longer tolerate the use of taxpayer-funds to effect bailouts of banks? Maybe this is the beginning of an attack on offshore banking havens? Or possibly the regulators are hoping to impose some market discipline on the banks, forcing depositors to review bank balance sheets before opening an account. Regardless of motivation this is a game changer.

So what is the impact of this ‘template’ for investors? By law, when you put your money into a deposit account, your money becomes a liability of the bank. Above an insured amount, you become an ‘unsecured creditor’ with a claim against the assets of a bank if it were to fail; your deposits are now pooled with other assets and divided amongst other creditors. We urge investors to consider any deposits above the insured amounts to be only as safe as the credit-worthiness and capital structure of the bank indicates. Only by understanding where you are in the creditor ‘pecking order’ will you avoid a ‘Dijssel-Bomb’ in the next phase of the on-going financial crisis.

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