Are European Officials Deaf to Investors?

Are European officials deaf to investors?

You might think so based on the recent column by Ambrose Evans-Pritchard in The Telegraph.  In the column titled, "EU plans for bondholder haircuts unsettles debt markets", he says:

Michel Barnier, the single market commissioner, will publish a “consultation paper” outlining ways to shield taxpayers from banking crises. It is the first stage of what will almost certainly become a binding law.

“We are pursuing the idea of a debt write-down or conversion to help stabilise a failing bank and reduce the need for public funds,” said an EU source.

Fears that this could evolve into a crusade against bondholders set off fresh jitters on EMU debt markets yesterday, pushing yields on 10-year Greek bonds to a record 12.59pc.

Portugal managed to sell €500m (£425m) of debt at a crucial auction but had to pay 3.67pc on six-month bills, double the rate in September. “It is an unsustainable dynamic,” said Lena Komileva from Tullett Prebon.

Credit Default Swaps on Irish bonds jumped 16 points to 620 after Switzerland’s central bank said it would no longer accept Irish debt as collateral.

The investors have just spoken again and they have spoken very loudly and clearly.  Investors are unwilling to buy someone else's losses regardless of whether the losses are in an individual bank or at the sovereign level.

Investors know that the global banking system and each bank in it was facing insolvency in 2008.  Investors also know that since then governments have pursued a strategy of trying to bailout and recapitalize the banks.

The question that investors have is which, if any, banks are now solvent?

This question is entirely reasonable, because investing in an insolvent bank is buying someone else's losses.

The problem European, as well as UK and US, officials are facing is how to answer that question.  Their first reaction was to run stress tests.  As George Osborne, the UK Chancellor of the Exchequer, observed in his column in the Financial Times:

 It is revealing that the tests conducted last July identified a capital shortfall of just €3.5bn. Yet less than six months later, Irish banks required 10 times that amount.... Europe cannot repeat the same mistake again. It is now clear the new stress tests must be much tougher.... We should look at ways of strengthening the credibility of these tests, including validation by bodies such as the International Monetary Fund.

Mr. Osborne correctly identifies the need for credibility in answering the investors' question about which banks are now solvent.

However, the International Monetary Fund does not provide this credibility.  Its funds for operating come from the countries that are asking it to review the stress tests.  This is an insurmountable conflict of interest that undermines the IMF stamp of approval on a new round of stress tests.

As readers of this blog know, there is a simple way to make the stress tests credible.  Stop hiding the data on which the results are based!

After announcing the results, make the individual asset-level data for each bank available so that the credit markets, including both investors and financial institutions, can confirm the results.  Doing this will immediately restore credibility.  It will also restore investments in and loans to the solvent institutions where the investors and lenders are willing to absorb future losses.  It will also allow the governments to focus on recapitalizing the insolvent institutions or overseeing their exit.