Friday, July 22, 2011

Latest European bailout buys time for implementing FDR Framework disclosure

European leaders unveiled their latest effort to address the sovereign debt and bank solvency crisis.  It is a fund to bailout countries and banks.

As regular readers know, bailouts do not address the underlying solvency issues of the countries or the banks, but rather buy time.  This time can be used to pray for a miracle or to actually address the underlying solvency problem.

Since I am an optimist, I will assume that the time will be used to address the underlying solvency problems.

For European banks, the first step in doing this is to adopt and implement the disclosure requirements of the FDR Framework.  This means providing market participants with access to all the useful, relevant information in an appropriate, timely manner.  For banks, this information is current asset and liability-level data.

Market participants will then use this data to determine which banks are solvent and which are not.  This is done by comparing the market value of each bank's assets to the book value of its liabilities.  If the market value of its assets exceeds the book value of its liabilities, the bank is solvent.  Otherwise it is insolvent.

Perhaps more importantly, everyone knows how much capital is needed by the insolvent institutions to restore them to solvency.  The insolvent banks can either be recapitalized by the national government using funds from the bailout fund or closed.

Adopting disclosure under the FDR Framework and combining it with the bailout fund allows each country to restore solvency to its banking system independent of its sovereign debt situation.

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