Bailouts or Bankruptcies? Europe Begins Working on Plan B for the Euro

World Bank President Robert Zoellick, International Monetary Fund President Christine Lagarde and German Chancellor Angela Merkel: Would it be better to rescue banks or states?

World Bank President Robert Zoellick, International Monetary Fund President Christine Lagarde and German Chancellor Angela Merkel: Would it be better to rescue banks or states?


Part 2: European Banks Would Lose €250 Billion in Own Capital

Even so, that might ultimately wind up being cheaper for taxpayers than the ongoing support of indebted states. That, at least, is the belief of German economists Harald Hau and Bernd Lucke, who have calculated a comprehensive scenario for what a wave of bankruptcies in Europe's banks could mean. Under the scenario, Greece and Portugal would undertake a debt haircut of 50 percent, with Italy, Spain and Ireland each eliminating 25 percent of their outstanding debt.

Under the scenario, European banks would lose more than €250 billion in equity capital, which would have to be replaced by government infusions. In Germany, around €20 billion in government money would be needed to shore up the banks. Deutsche Bank would require €3.7 billion and Commerzbank around €6 billion.

Together, the euro-zone economies would also have to cover the losses at financial institutions in the countries that went bust -- a figure the economists estimate to be at around €180 billion. As Europe's largest and most solvent country, Germany would have to foot a large portion of that bill.

Sharing the Burden

But the economists still believe it would be cheaper to provide banks with fresh capital than to continue providing ongoing rescue packages for overly indebted countries. In addition, since governments would be given shares of the banks in exchange for the aid, taxpayers would not be left alone to carry the costs of the crisis.

"If the recapitalization is executed at market prices -- in other words, based on the current share price -- then the losses from the expected debt haircut will be carried by the old shareholders," said Hau, who teaches economics and finance at the University of Geneva and at the Swiss Finance Institute. "Initially it would cost taxpayers nothing because they would be given valuable company holdings in exchange."

There would, of course, be one exception: If a bank's losses became so high that they drained their capital entirely, then taxpayers would first have to replenish their equity capital. "Then there would be an actual loss, and there's no way around that," Hau said.

By Hau's calculations, that would apply to only one bank in Germany -- Hypo Real Estate, which he estimates would require around €500 million in capital. Losses of around €30 billion would be expected in the banks in the worst-hit crisis countries.

Hau is convinced that this path is the best one to take. "The bailout package merely protracts the solution to the crisis, but a debt haircut would at least be the beginning of a solution." He also believes his proposal would be fairer. "With a debt haircut, around 80 percent of the costs would be carried by actors in international finance -- from private investors, funds and insurance companies," he said. "Taxpayers would be hit less hard."

As good as that may sound, considerable uncertainty remains over the side effects a debt haircut strategy might have. How long, for example, would banks continue to have to rely on state support? And would governments ever be successful in selling their shares in the banks?

Nevertheless, in the event of state bankruptcies, the euro rescue fund would still be needed because it would take time before crisis countries were able to borrow on their own again from capital markets. Until that time, they would have to be supported by the solvent euro-zone countries. That, it would appear, is unavoidable.

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