Chief Economist at Germany's Largest Bank Calls for 150 Billion Euro Bailout

More bad news for the EU this week as it continues to grasp for a solution to the ongoing banking crisis. The Chief Economist at Deutsche Bank, the largest bank in Germany, has openly called for 150 billion Euro bailout in an interview with a prominent German newspaper.

Readers will recall that Italy's largest banks have been collapsing in the markets under the weight of an absurd 360 billion euros of nonperforming loans, which account for 18% of their total loan portfolios. Given that nonperforming loans are just a nice way of saying "loans that will probably not be paid back," this constitutes an existential threat to the banks and, by extension, possibly the Italian financial system.

Predictably, this has been blamed on the successful Brexit vote, though the claim made very little sense, as we explained recently.

In response to this newly urgent crisis, Italian Prime Minister Matteo Renzi was pushing for a proper bailout of the banking system. European Union rules, however, technically prevent a full taxpayer-funded bailout, and require what is referred to as a bail-in first.

Given the obvious and justified unpopularity of bank bailouts, an alternative solution would seem preferable. The EU bail-in might prove to be an exception.

What's a Bail-in?
Basically, a bail-in requires that investors, bondholders, and then even uninsured depositors lose part of their money to the bank. While investors and bondholders ought to bear the loss in a failing company, the inclusion of uninsured depositors is a very different animal.

Under this mechanism, the depositors are effectively viewed as creditors. And in a way, this makes sense. After all, when you deposit money at the bank, you are effectively loaning the bank money, and this is why you (used to be able to) get some non-negligible amount of interest for your trouble. In a bail-in, part of this "loan" to the bank is simply waived. Part of the bank's liabilities disappear, improving their balance sheet and their chance of surviving

But while deposits are a loan in some sense, they are generally conceived of as something quite different. A loan is presumed to carry some risk. Meanwhile deposits are generally seen as risk-free, at least in our era of central banking and heavy regulation. The prospect of the bail-in changes this.

Once the first depositors of Europe Proper start having their deposits confiscated to help out an unstable financial institution, this perception of deposits as risk-free will promptly evaporate. If that happens, a bank run will follow, as depositors rushyy to withdraw their funds before any of their deposits suffer the same confiscation. This has the ultimate effect of further destabilizing the very institutions the bail-in was meant to save.

This occurs because no bank can survive a bank run. Under a fractional-reserve system like ours, no bank ever has enough cash on hand to pay off all their depositors' claims because some of the money has been lent out. While this may seem unsavory, there's nothing secret or illicit about it. Take a look at the balance sheet of any bank, and it will be perfectly apparent. For instance, here's a snip of Deutsche Bank's balance sheet as of 12/31/2015.

How this works is that the top three assets listed are all basically liquid and can be readily used to pay depositors. From there, each successive asset becomes more difficult to convert to cash, with some of them being effectively impossible (goodwill).

Thus, we can compare the total of the top three assets (132 billion euros total) to the much larger deposits listed in liabilities (567 billion euros). If a substantial portion of Deutsche Bank customers suddenly began to worry and pull their deposits out, Deutsche Bank (like any other bank) would have to get creative to meet the demands--possibly selling off securities, taking out loans from other banks or the central bank, and if things got really bad, calling in some existing loans and credit lines. If the problem is not confined to Deutsche Bank and many banks experience this panic simultaneously--a likely outcome if the bail-in mechanism is used on the Continent--it becomes even more difficult to resolve. This is the worst case scenario for the EU financial system, and yet as things stand currently, it is also their official remedy for failing banks.

That is, the EU's solution for the banking crisis is, in effect, to induce a larger one.

Deutsche Bank's leadership is now weighing in to try to prevent the catastrophe this would likely unleash in the short-run. Their economist's solution is to do a standard bailout instead, as the US did in the 2008 crisis. Which leads to a useful question...

Is a Bailout Better?
Like most economic questions, the answer to this one is "It depends." And in particular, it depends on your time horizon. Assuming the government itself won't go broke from the initiative, a bailout can likely succeed in minimizing an immediate crisis. However, it doesn't resolve the underlying problems that caused the crisis, and it all but ensures another one will occur in the future. The best case scenario is kicking the can down the road.

For this reason, it is highly attractive politically. Yes, a bailout is effectively corporate welfare for the most reckless and terribly managed institutions. That rarely plays well on the campaign trail. But it plays better than a complete financial crisis. Assuming electoral success or protecting one's legacy are key goals for the decision-makers, bailouts are an excellent idea.

If one's goal is long-term financial stability, not so much.

Each bailout paves the way for the next. Other institutions observe that their peers suffered no consequences from making risky financial bets that lost money. This encourages all of them to take more such bets in the future. If the bets work out, they get to keep the profits. If they do not, the taxpayer bears the losses. Economists refer to this as the problem of moral hazard. People that don't bear the costs of taking risks, tend to take more risks. If those people are bankers, it doesn't end well.

In the long-run, the best approach is to let failing institutions actually fail. Deposits, like Puerto Rican bonds, are never truly risk-free. The banking system will only have a chance at stability when this fact is widely understood--and when banks are forced to compete for customers by showing just how sound and conservative they are, rather than simply pointing to a government guarantee.

What Happens Next?
Deutsche Bank's recent pronouncement should be properly viewed as a recognition of reality. The goal of the EU and the European Central Bank is to prevent a short-term crisis, and the bail-in regulation is unlikely to fulfill this purpose. Since a free market solution is not going to make headway in the EU, a bailout is the default alternative.