First Liquidity, then Solvency

First ECB, then EFSF

Tightening money market conditions in Europe have now claimed their first victim, Dexia, and in so doing shifted the focus of policymakers from sovereign debt to banking recapitalization. But it is just a change in approach; the underlying problem remains the same.

The demise of Dexia should remind everyone that liquidity kills you quick. In this regard, Trichet’s reminder that no European bank should worry about liquidity is reassuring, or should be anyway.

In plain language, he is signalling willingness to move wholesale funding markets onto the balance sheet of the ECB if need be. Creditors unwilling to roll their exposures to Drexia, or any other troubled bank, can instead make deposits at the ECB, and the ECB will take over the lending to Drexia.

This solves the liquidity problem, so no quick death. Even insolvent banks can continue in business for quite a while provided their immediate liquidity needs are met, so solving the liquidity problem buys time to solve the solvency problem.

So what about that solvency problem? The solvency problem is at heart really just a problem of recognizing and then allocating losses that have already happened. It is about which balance sheet takes the losses. That is the question at the center of the current debate about how exactly to recapitalize the banks.

If France and Germany each separately take responsibility for recapitalizing their “own” banks, then the losses of the French banks are absorbed by holders of French bank equity and the French taxpayer, and the losses of the German banks are absorbed by holders of German bank equity and the German taxpayer.

If however a Europe-wide institution, such as the EFSF, does the recapitalization, then the losses are spread Europe-wide. But also, and this to my mind is the more important point, if a Europe-wide institution does the recapitalization, that is the moment when it will be easiest to establish a Europe-wide regulatory apparatus.

Learn from the US mistake. If you recapitalize first and reform second, you won’t get the reform you need.

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