Monday, December 6, 2010

Asset Level Data: The Firewall to Stop European Contagion and Bailouts

The global regulatory and central banking community is discovering how hard it is to stop market discipline, particularly when it lacks the credibility to prevent what it sees as vigilante justice.

Market discipline is being led by credit analysts who, in the absence of the asset level data to prove otherwise, are assuming worst case losses on the loans extended during the credit and real estate bubbles.  

By definition given the amount of leverage in the global banking system at the start of the credit crisis, worst case losses overwhelm the financial resources of both the banks holding the assets and the governments that guaranteed the liabilities of these banks at the start of the credit crisis.    

The global regulatory and central banking community insists that the credit analysts are wrong and that they have the situation under control.

What is the basis on which the global regulatory and central banking community make their assertion?  Presumably they make this assertion because of all the non-bank market participants they and only they have access to the actual performance of the assets on the balance sheets of the banks.  

How do they access this information?  As described by Andrew Haldane of the Bank of England in a previous post, it involves global regulators sending out large numbers of examiners to look through the books of individual banks and requiring banks to submit vast quantities of data to them.  Only the examiners/regulators see the bank data.  Only they analyze the data.

Since only the global financial regulators see the data, this puts them into a position where other market participants have to trust that the global financial regulators are accurately representing that data.

This trust was readily given before the credit crisis.  However, since the beginning of the credit crisis, credit analysts and investors have had no reason to trust the global financial regulators.

For example, Ken Rogoff, the former chief economist at the International Monetary Fund, said in a December 2010 Bloomberg interview that took place at a time when additional capital injections were being discussed for banks that had passed the stress test in Ireland, 
"the bank stress tests carried out in Europe in July were 'really scary' and 'pathetic.'
'We were told everybody is fine, there is nothing to worry about,'... 'now their [the European financial regulator's] credibility is less than ever.'”
A Bloomberg article provides another example of how the lack of trust effects the markets.  
"Spain says the government’s finances and the country’s banks are sound. The lenders are 'fundamentally healthy,' Jose Luis Malo de Molina, chief economist of the Bank of Spain, said in a news conference in Madrid yesterday. 'The Spanish financial system does not have a problem of deep frailty such as the Irish economy has.'
The country’s lenders have about 30 percent of their medium- and long-term debt maturing by December 2012, according to the Bank of Spain’s October financial stability report. ...
Cajas at Risk
'Asking the Spanish banks how they are going to meet these refinancing needs is absolutely a fair question for them,' Claire Kane, a banking analyst at MF Global in London, said in a phone interview.
Four months after the Bank of Spain said publication of stress tests of Spanish lenders 'confirm the soundness' of the country’s banking system, investors are again driving up their financing costs. Investor concerns are most likely to focus on the needs of Spain’s savings banks, said Daragh Quinn, an analyst at Nomura International in Madrid.
In short, despite the protestations of the Spanish government about the soundness of the Spanish banking system and the government's ability to cover any shortfall, investors do not trust what the government is saying.

Is there any reason for investors to take this position?  Unfortunately, yes.  While there are many more examples including the stress tests discussed above, here are a couple of recent examples:
  1. The supervisory report on RBS's acquisition of ABN Amro shows that the regulators clearly did not understand the quality of the credits that both institutions had on their balance sheets and the lack of capital to absorb the losses on these credits.  
  2. The Irish government set up a bad bank to acquire the dodgy assets from the Irish banking system and despite having claimed they bought up all the dodgy assets multiple times before, they are going to purchase more dodgy assets with proceeds from the bailout.
This lack of trust creates problems for reasonable solutions for how to stop the contagion that threatens to meltdown the European Union.  For example, Sir John Gieve, a former deputy governor of the Bank of England, observed in the Telegraph,

"One lesson of 2008 is that once market confidence begins to ebb, it develops its own momentum. Any bank [government] requires a continuous flow of funds and the question ceases to be whether it is solvent as a going concern and becomes simply whether it will be able to refinance maturing debt at an acceptable price. The worry that it won’t becomes self fulfilling. And in the complex and opaque network of international finance doubts about one bank [government] swiftly spread to others.

The euro area is standing on the brink of such a meltdown today. It needs urgently to establish a firewall against contagion by identifying a country which can demonstrate its ability to meet its debts and then giving it full support. I suspect it could still do this in Spain. For Spain, with continuing access to finance at reasonable rates, should be able to service its own debts and support its banks as it wants.
But it is failing to persuade the markets of this because it cannot be sure of continued funding at affordable rates and because it appears still to be in denial about the true level of bad debts in its banking system (widely thought to be at least €50bn (£42bn) more than published).
The best course is for Spain to announce a credible plan for its banks with fiscal retrenchment and supply side reforms, and for the euro area to back that with facilities, at a modest spread over bunds, which are sufficiently long term and sufficiently large to give Spain time to earn its way out of trouble. That would allow the ECB to reinforce the firewall by increasing purchases of Spain’s bonds. In time it should then be possible to manage the debt restructuring Ireland and Greece need.

His proposal for restoring confidence relies on the markets trusting the Spanish government's statement about what the true level of bad debts in its banking system are.  

Why would the Spanish regulators be more adept at this than the Irish regulators?  Presumably, both have the same training and motivations.  

Why should investors trust them?  If the investors do not trust the Spanish regulators, why should a bailout of Spain act as a firewall?

As mentioned previously on this blog, there is only one way to restore trust and erect a firewall against contagion.  Governments must make the statement about which banks are or are not solvent in their system and make the asset level data available to support it.  

It is requiring the disclosure on a current basis of the underlying asset level data that restores trust, confidence and ends the contagion.

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