Mervyn King and the Financial Policy Committee embrace the FDR Framework [update]

The Telegraph article on Mervyn King and the initial report of the Financial Policy Committee appears to indicate that the FPC embraces the FDR Framework.

"Sovereign and banking strains are the most material and immediate threat," the committee, chaired by the Bank of England governor, said in its inaugural report. 

The committee called for banks to improve their disclosure of sovereign and bank sector exposure and also warned that authorities needed to keep a closer eye on the explosion of "opaque" products such as exchange traded funds (ETFs), which banks increasingly use to raise funds. 

Regular readers know that the FDR Framework requires improving disclosure by banks of their sovereign and bank sector exposure.  Specifically, the FDR Framework requires them to disclose to market participants all their current asset and liability-level exposure.  It is only with this data that market participants can address the issues of individual bank solvency and the risk of contagion.

... Speaking at a news conference hours later, Sir Mervyn King said uncertainty over exposure to countries such as Greece could lead to a "crisis of confidence", which posed a bigger risk than direct exposure. 

"There is always uncertainty about the scale of exposures, which counter-parties out there are the ones which are heavily exposed," he said. 

"That uncertainty can lead at various points for funders of banks...to draw back and there can be a crisis of confidence in sentiment in which people say 'I simply don't understand the complexity of the interconnectedness of these exposures and I just won't take the risk of lending'. And that is the bigger risk, I think." 

Without disclosure, there is nothing to anchor investors or regulators.  It becomes a matter of psychology.  Do the investors believe the banks are solvent or not.  If not, then the banks are subject to an old fashion bank run which the regulators will attempt to head off.

With disclosure, investors and regulators can actually determine if the banks are solvent.

Mr King also said that the ongoing crisis in Greece was not a matter of liquidity, but solvency, and a build-up of large amounts of debt: 

"Right through this crisis...an awful lot of people wanted to believe that this was a crisis of liquidity. It wasn't, it isn't. And until we accept that we will never find an answer to it. It was a crisis based on solvency or to be more precise, the build up of very large amounts of debt where concerns crept in on the ability of the borrowers to repay that debt," he said. 

The report came as EU leaders scramble to avert a Greek debt default that would send shockwaves through international markets. 

Mr. King has eloquently restated one of the central themes of this blog:  the financial markets froze when market participants could not answer the question of who is solvent and who is not.  This was also the finding of the Financial Crisis Inquiry Commission.

As Mr. King says, it is only when we accept that the issue is a question of solvency and the related issue of the ability of borrowers to repay their debt that we will find an answer.  When we do accept this, the answer we will find is the adoption and implementation of the FDR Framework.

Update:

Both the Guardian and Bloomberg expanded on the need for disclosure to address contagion concerns.

According to the Guardian article,

The crisis enveloping the eurozone is a "mess" that poses the "most serious and immediate" risk to the UK banking system, Sir Mervyn King warned on Friday as he called for banks to provide more information on their exposures in the region. 

In his new role of chairman of the financial policy committee (FPC), the new "guardian of the resilience of the UK financial system", King also warned that banks may be providing a "misleading picture of their financial health" if they were not making big enough provisions for borrowers having difficulty repaying loans. So-called forbearance has taken place in up to 12% of mortgages, including 30-80% in the commercial property sector.

This is the reason that under the FDR Framework, banks have to provide their current asset level data.  Market participants can analyze this data to determine if the provisions are large enough.

... UK banks' exposure to Greece directly was "remarkably small", he said, but he warned that the bigger risk was a "crisis of confidence". 

"There is always uncertainty about the scale of exposures... which counter-parties out there are the ones which are heavily exposed," he said. "That uncertainty can lead at various points for funders of banks... to draw back, and there can be a crisis of confidence in sentiment." 

He said more data was needed about exposures to allay any unnecessary concerns. 

Mr. King has identified why the FDR Framework restores and maintains confidence in the financial system.  With the data, market participants know what is happening.

According to the Bloomberg article,

“Direct U.K. bank exposures to those economies are limited,” King said, referring to euro members whose borrowing costs have soared as Greece tries to stave off a default. “But experience has shown that contagion can spread through financial markets, especially when there is uncertainty about the precise location of exposures.” 

The FPC said strains in the euro region pose a risk to Britain’s lenders because U.K. banks’ combined claims on France and Germany account for about 130 percent of their so-called core Tier 1 capital, with close to half of that representing claims on banks. 

“Any escalation of stresses could also be transmitted via interconnected global markets, including via the U.S., leading to a tightening of bank funding conditions,” the panel said. “Such contagion could be amplified if bank creditors were unsure about the resilience of their counterparties.” 

The panel has identified an important benefit of implementing the FDR Framework.  With the disclosure required under the FDR Framework, bank creditors can determine which banks are solvent and which are not.  As a result, the risks of contagion are minimized.