Looking Ahead: One-Size-Fits-All-Approach Won't Work for EU Debt Crisis

As European bank depositors, bank creditors and bank stockholders look back nervously at what happened recently in Cyprus, there is increasing speculation about what might happen to Slovenia and even some other European countries in relation to bank restructuring.
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As European bank depositors, bank creditors and bank stockholders look back nervously at what happened recently in Cyprus, there is increasing speculation about what might happen to Slovenia and even some other European countries in relation to bank restructuring.

U.S. investors have deposits, bonds and stock tied up in Europe's banks too, so this is most certainly not just a European issue.

Many U.S. and European investors now want to know, was the use of deposits in restructuring the Cypriot banks a one-off? And how safe are senior bondholders in European bank-restructurings after a key lender in Cyprus, Laiki Bank, was forced to effectively wipe out its senior bondholders?

Investors are even hungrier for more basic information such as, what are the long-term future capital requirements of Europe's banks? Clearly, arriving at an answer to this question is very difficult until detailed and uniform stress tests are carried out across Europe, but the situation is even more complex than that.

For example, it's not even clear at the time of writing, what are the precise capital requirements of Slovenia's banks?

The country itself has been very straight on the issue saying the bill will top $1.3 billion, but the OECD recently seemed to question this, particularly as the capital requirements are driven by a very common problem in Europe -- property-heavy loan books.

To be fair to policymakers in the European Union, ECB and the IMF, each European banking market is different; hence the solutions cannot be, by definition, uniform.

Ireland, which poured more than $83 billion into its undercapitalized banks, did not have a major issue with the exotic derivative products that caused so many problems for U.S. lenders, but did have a major problem with plain vanilla real estate loans given to property developers.

Apart from loan exposures being different, the core building blocks of each banking system are different. The ratio of deposits to loans is radically different across Europe, the ratio of senior and junior debt is different and the ratio of corporate to retail deposits is also usually different across markets.

With different capital structures, different deposit patterns, different ownership structures and different debt obligations, designing a one-size-fits-all European solution for designing bank restructures is a big challenge.

But from the bitter experience in Ireland, where 40 percent of economic output was used to shore up bank capital levels, the best approach for bank pain is best summarized as -- take the pain early, take it simply and take it cheaply.

An equally important lesson to learn is make sure that restructuring of the domestic banking industry does not spill over negatively on foreign banks operating in the same jurisdiction.

In Ireland, on painful reflection, the domestic banking industry took a long time to stabilize, considering the problems first appeared in 2008. The cost, as described above, was very considerable and Ireland's Central Bank governor, Dr. Patrick Honohan, has spoken out on this point.

The Irish government's bank guarantee of 2008 "propelled Ireland to a very stressed level of public indebtedness" and the refusal of external lenders to allow losses to be forced on senior bondholders further increased losses, Dr. Honohan commented last September.

Of course, there is a constellation of opinions on this last point, particularly now that deposits have come under the microscope.

But where Ireland did score highly in all of this, was keeping its attractive offering to international banks intact despite the efforts and costs needed to stabilize its domestic banking system.

For example, employment losses in Ireland's foreign banking sector have been recovered since the financial crisis and major global players have kept faith in Ireland despite the tribulations of the domestic banks in Ireland. For instance, financial services companies including PayPal, Fidelity, Northern Trust and Deutsche Bourse put investments into Ireland during 2012.

These type of companies usually bank outside Ireland, which has left Ireland in the happy position of keeping its domestic banking problems sealed off from the foreign banking sector. The country's International Financial Services Center (IFSC), Ireland's equivalent of London's Canary Wharf, also weathered the storm well in the last few years, considering what happened to the domestic Irish banks.

So the lessons from Ireland are clear -- for one, the sooner problems are tackled, the better. Second, the cost to the national balance sheet must be foremost and thirdly, never accept an excessive government and regulatory response that harms badly needed inward investment from the global banking sector, which is often operating in a different way to the domestic banking sector.

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