Preserving banking system solvency: the roles of inflation and fiscal strength

The likelihood of a systemically important financial institution becoming balance sheet-insolvent depends on two key factors.  The first is the share of the financial institution’s  net domestic-currency debt in its total net debt and the willingness of the monetary authorities to inflate away that debt.  The second factor becomes relevant if either the financial institution has a significant net foreign currency liability, or if the monetary authorities are unwilling to generate the necessary inflation.  This second factor is the size of the financial institution’s  ‘solvency gap’ (at whatever rate of inflation the central bank generates) relative to the fiscal strength of the government  that assumes responsibility for that institution.  Even a very bad bank can survive if it is backed by a fiscal authority with sufficiently deep pockets. A moderately back bank may fail if the fiscal authority backing it does not have the capacity to make a sufficiently large resource transfer to it.

When most of the liabilities of the banks are domestic-currency denominated (which is the situation of the US banks), solvency is not an issue as long as the central bank can be convinced to generate a sufficiently high rate of inflation.  Unexpected inflation is an especially powerful instrument for blowing away domestic-currency debt.  The late Rudi Dornbusch used to say that there is no domestic debt problem (public or private) that cannot be solved by a determined burst of hyperinflation.

Inflating away the debt of thebanking system will be a political problem in those countries or supranational entities where the central bank has been made independent and has been assigned price stability as its overriding objective. The Bank of England and the ECB fall in that category.  The Fed does not, both because it has a dual mandate rather than a lexicographic price stability mandate and because it is less independent of both the US executive and the US Congress than are the Bank of England and the ECB as regards their executive and legislative counterparts.

Inflating away the debt also does not help when the debt is mainly foreign currency denominated.  Iceland, Switzerland and the UK are in that position.  For them, and for the euro area countries (and for all countries whose central banks cannot be pushed around too much), it is the relative size of the bad banks’ solvency gap relative to the fiscal strength of the government ultimately backing the banks (perhaps indirectly through the central bank, perhaps directly) that determines the soundness of the banking system.

Large vulnerable banks in small countries and/or in countries with weak central fiscal authorities are therefore bad news as regards banking solvency.  Iceland and Switzerland come to mind. Pooling resources with other countries may be the only way out, as the magnitudes of the sums involved dwarf the current resources of the IMF, which today can only handle systemic crises in the smaller emerging markets and developing countries.   Such mutual insurance would benefit even the UK, because of its large banking sector relative to its GDP.

Small EU countries with large banking sectors (Belgium, the Netherlands, Luxembourg) have already engaged in joint interventions to support failing banks.  But so has France, which engaged in a cooperative bailout of Dexia with Belgium and Luxembourg.  It is probably fair to say that no European country, even Germany, is large enough, as regards its fiscal capacity relative to its banking sector’s potential solvency gap, to face the insolvency music alone.  Countries with relatively sound banking systems, like Italy (if we ignore Unicredit), may nevertheless be up against it because their fiscal capacity is seriously limited.  If ever a task was made-to-measure for the EU, this is it.

Finding good metrics for computing the relative magnitude of the banking system’s solvency gap relative to the fiscal strenght of the fiscal authority ultimately underwriting the banking system’s liabilities will be an interesting task.  I may set it as an exercise for my LSE students, who between them probably cover most countries of interest.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

Maverecon: a guide

Comment: To comment, please register with FT.com, which you can do for free here. Please also read our comments policy here.
Contact: You can write to Willem by using the email addresses shown on his website.
Time: UK time is shown on posts.
Follow: Links to the blog's Twitter and RSS feeds are at the top of the page. You can also read Maverecon on your mobile device, by going to www.ft.com/maverecon