Month: August 2011

Around the time of the EU/IMF deal for Ireland, Patrick Honohan advocated that it would be more effective if the financial risks associated with fixing the Irish banking system could be shared across the European system, rather than just making ‘plain vanilla’ official loans to the Irish government.

In her Jackson Hole remarks, Christine Lagarde agrees:

Second, banks need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary. One option would be to mobilize EFSF or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns.

Today’s FT lead article also makes the same point  – but where the EFSF would guarantee funding lines for banks, rather than inject capital.

John Fitzgerald assesses the prospects for the Irish fiscal situation in this Sunday Business Post article.

This VOXEU article looks at some behaviourial motives that influence ‘borrower runs’.

The Sunday newspapers certainly show the debate about mortgage debt forgiveness is gathering steam.    Although policy in this area reflects a complex balancing of social and economic factors, an unavoidable aspect is the potential trade off between costs of any additional induced bank losses and the benefits debt forgiveness.  

Just two quick (related) points.   First, central to the argument for debt forgiveness is that banks have already made provisions for substantial mortgage debt-related losses.    I don’t think Greg Connor’s point in an earlier thread about the weak connection between existing accounting-determined write-downs and the case for forgiving debt has received the attention it deserves. 

This mixing up of accounting loss appraisal and debt forgiveness confuses an honest attempt to guess at likely losses (loss appraisal) with a completely separate activity which is trying to recover as much as is reasonably possible (debt management). Mixing up these two activities in this way would destroy the objectivity of bank accounting standards. It goes against every principle of accounting objectivity if accountants giving an honest appraisal of likely losses generate a change in bank cash flows. How could a bank accounting system by expected to be objective about loss appraisal in that case? Very bad notion.

Second, the concept of the debt Laffer curve is a useful tool for thinking about the potential trade off.   If we are to the right of the peak of the curve, so that reducing the debt actually increases the expected value of repayment, then the case for forgiveness is strong – indeed banks would not need much prompting.    This is most likely to be the case where banks would suffer large losses if borrowers walk away or if the bank pursues repossession.    The current regime of impossible bankruptcy/full recourse/extensive forbearance would appear to make it unlikely we are to the right of the peak.    I would be interested in people’s views.