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Interest rates and banking solvency


6 April 2020 (latest update: 4 May 2020)


 
options for banking insolvency
 

The corona crisis can bankrupt people and corporations because their income suddenly vanishes while many of their expenses continue, for instance food, rents and interest payments on loans. During such an emergency it may be sensible for governments to support people and businesses when they lose their income. Choices will then be made so political and economic considerations come into play.

Governments should define which businesses are essential and should not go bankrupt. They should also ask themselves how much fall-out is acceptable? If businesses go bankrupt, the economy will be harmed and people will find it harder to make a living. Supporting people and businesses in these exceptional times makes sense because of the suffering that can be avoided. It also makes economic sense if the total cost to the economy is reduced.

Banks are especially vulnerable because they are more leveraged than other corporations. If 10% of the loans are not repaid, most banks are already bankrupt because their equity is around 10% of their balance sheet. The equity of most corporations is around 50% of their balance sheet but they often depend on bank credit. Letting banks fail could devastate the economy. The situation is therefore dire.

To see how a resolution may play out it is important to understand that banks have three types of capital, which are shareholder equity, debt held by bondholders and deposits. If a bank goes bankrupt, nothing remains for shareholders and most likely little will be left for bondholders. What remains is for depositors. In many countries there is a deposit insurance that could mitigate the losses of account holders.

Letting things fail is not acceptable. There are two well-known scenarios to resolve a banking insolvency:
  • bail out: banks sell loans to the central bank for currency so they can meet their obligations. This is considered to be a subsidy to the banking sector.
  • bail in: banks are recapitalised by account holders. For example, 25% of the balances will be debited and depositors receive bank shares in return.

  • There is an alternative. The insolvency is also the outcome of markets for money and capital failing to reach equilibrium because interest rates can't go below zero. Equilibrium interest rates probably are significantly below zero because central banks can print money like there is no tomorrow and interest rates still do not rise as a consequence. Investors have a huge appetite for cash because the safety of cash is not correctly priced in the market.

    A holding fee (demurrage) on central bank currency at a rate of 10-12% per year could reveal the actual interest rates in the market. Bank accounts will have negative interest rates too. But bank accounts are safe if the central bank supports the banking system so the market price of safety should also apply on bank accounts. This is part of the Natural Money proposal (see: A Short Introduction to Natural Money).

    The equilibrium interest rate on euro and US dollar government bonds may be below -3% at present. If interest rates were to reach their equilibrium levels then the banking sector may suddenly become solvent again. That is because of discounting. If interest rates go down then the present value of future payments rises. As a consequence the value of performing loans on the balance sheets of banks rises and that counters the losses on bad loans.

    When non-performing loans should be valued at market value then that should also apply to performing loans. If that is not possible then banks only appear insolvent while they are solvent in reality. In that case they should be allowed to write-off non-performing loans over a longer time frame because future revenues probably allow for that. The impending banking insolvency may therefore be easier to solve than most experts believe.

    And negative interest rates can also help to end the impending economic depression (see: The Miracle of Wörgl). That may be good to know too.