The 'doom loop' between banks and governments

When Cyprus's banks were rescued big depositors were expected to make a contribution

Can China and Europe afford to support their banks?

Five years after the global financial crisis, US banks are largely back on their feet, but for the eurozone and China, questions remain.

For the eurozone, three years after the start of the crisis, there is agreement that the "doom loop" must be broken.

This "loop" is the relationship between banks and governments whereby banks that need help add to a government's budget deficit, which in turn can lead to a rescue of the whole country.

Ireland comes to mind as the government bailout of its banks led to the country's deficit hitting 32% of GDP and triggered a rescue by the eurozone.

When Spain needed help with its banks last year, it was offered help from the euro area's rescue funds and was not put into a full rescue programme - which was one step toward breaking that "doom loop".

Cyprus threw a spanner in the works when its depositors were expected to contribute to the bank rescue.

Enough help?

But, now there are details of how the bank recapitalisation will work. That loop won't be completely broken as governments will bear some of the costs.

The ESM rescue fund can directly recapitalise banks if requesting countries put in money in the following ways:

• For banks with less than a minimum amount of capital, governments must contribute to bring it up to a tier one common equity ratio of 4.5%.

• For banks that meet that minimal capital requirement, governments would have to put in 20% of the recapitalisation funds, to fall to 10% after two years.

Terms could change in "exceptional cases". In other words, in most cases, the "doom loop" is weakened but is not broken.

And, retroactive applications (such as by Ireland) look like they will be decided on a case-by-case basis.

A crucial point is that of the ESM's 500bn-euro lending capacity, just 60bn euros can be used to recapitalise banks (though this figure can be raised).

It is important because the key for whether a banking crisis can be averted is whether the country can afford to recapitalise banks. If it overwhelms the government's fiscal position like in Ireland, then it would end in crisis. If the ESM is limited and the governments have to shoulder some of the burden, then that question of affordability remains.

The UK and US are examples of where the banking crisis didn't result in sovereign rescues - though there is, of course, other fallout.

This is also the big question for China. Can it afford to recapitalise its banks?

Different problems

First, there are notable differences between the Chinese and Western banking systems.

The recent spike in the rate that banks charge to lend to each other in China is due to the Chinese government reining back credit. I wrote about the record high rate in a prior post.

The cash crunch is a result of the government's clampdown on lending to unprofitable ventures. China is even willing to accept slower economic growth to do so.

Overnight, though, the tensions eased once the central bank reportedly intervened to tell banks to lend to each other. The reason that China can avert a severe cash crunch in a day is because most of the banks are state-owned. It can tell its banks to lend to each other and that brings the rate down.

Another important difference is that the shadow banks in China are not the same as the West. They are essentially unlicensed banks and there aren't a lot of complex derivatives in the Chinese banking system, unlike the US.

The government is clamping down on lending after the vast credit surge since the global crisis. The 4 trillion yuan fiscal stimulus unleashed then was largely financed by the banks. The concern is that bad loans could be mounting on the banks' balance sheets.

Thus, the "doom loop" exists in China too, as it has for decades.

But, a key difference from the West is that the government can alleviate the credit crunch if it wants too, as it just has. So, unlike the West, the Chinese credit crunch is largely self-imposed.

Of course, the shadow banking system raises questions about how well the system is being regulated and whether the government's control is that complete. This is clearly why China's banks are again in the headlines.

Just bear in mind that the most important question is whether it can afford to recapitalise its banks. Until there is more clarity on the banking system, that is worryingly hard to answer.