Finland Trying to Dictate Terms of Spanish Bank Bailout: “No Funds to Bad Banks”

The Finland effort to dictate terms to the Spanish bank bailout may well turn out to be noise, but it is yet another indicator that despite the general optimism about a rescue, there are a lot of details to be nailed down. In addition, as we have pointed out, some of the pieces that do seem to be in place, such as having the bailout money be an obligation of Spain, are contrary to the objective of reducing Spain’s borrowing costs.

As Bloomberg reports:

Finland doesn’t want any of Spain’s bailout to prop up unhealthy lenders and expects some troubled banks to be split up as the northernmost euro member outlines the conditions it understands are attached to the rescue deal agreed on June 9.

“The unhealthy banks should be brought down or some banks should be possible to chop up” so that the healthy parts continue and the rest ends in a so-called bad bank, Finnish Prime MinisterJyrki Katainensaid in an interview in Norway today. “There must be a possibility to restructure the banking sector because it doesn’t make sense to recapitalize banks which are not capable of running.”

This may sound appealing on the surface, but it isn’t anywhere near that cut and dried. Earth to Finland, when you set up a good bank/bad bank structure, you ALSO need to fund the bad bank. This was a huge bone of contention in the US savings and loan crisis. Congress was very unhappy at having little choice but to fund the Resolution Trust Corporation, which required working capital (mainly funding of the assets of the bad bank) of $50 billion. One of the results was that Congress pressured the RTC to wind up sooner rather than later, and some analysts have argued that forcing the RTC to sell off some of its assets faster resulted in worse prices for the taxpayer.

In addition, the good bank/bad bank structure that generally gets the highest marks, the program in Sweden in the early 1990s, gave the asset manager the authority to extend more credit. In other words, when the asset manager determined loans in the “bad bank” were actually good loans, they could keep the borrower alive.

The second issue with a good bank/bad bank structure is that how long you have to fund the bad bank depends on how long it takes to liquidate the loans. The S&L crisis took place against the backdrop of a nasty but short recession. The overall strength of the underlying economy encouraged various investors to swoop in. By contrast, there are now a lot more banks sitting on dud assets (as in there is a ton more supply) and the prospects for the Spanish economy are far from robust. This indicates that any bad bank would probably need to be funded for quite a long time.

Note I’m not saying a good bank/bad bank structure might not be better than the alternatives, but the Finnish PM appears to be pumping for it to sound responsible and minimize disbursements to Spain. An IMF study of 124 banking crises concluded that recognizing losses early led to lower total rescue costs. But the reason the authorities keep entering into rolling “prop up the bank” exercises is that the cost of resolving sick banks typically looks too scary and large to present to taxpayers, so the banks are put on what turns out to be more expensive, protracted intensive care treatment. In other words, doing a bank rescue right is more costly, not less, in the short run, which is why political leaders have preferred to zombify rather than clean up their banking systems.

This post originally appeared at naked capitalism and is posted with permission.

One Response to "Finland Trying to Dictate Terms of Spanish Bank Bailout: “No Funds to Bad Banks”"

  1. DiranM   June 13, 2012 at 2:58 am

    It is bad enough have a slew of zombie banks in the Eurozone, but what about the Zombie countries like Greece, etc.? The same logic applies here for EU policy makers, keep Greece as a Zombie member rather than clean up the mess. The Greek political elite are themselves looking more and more like the living dead.