Spain and Italy show that the key to solving the European sovereign debt crisis is current asset level disclosure

A Wall Street Journal article laid out how the European sovereign debt crisis is linked to the bank solvency crisis.  To solve either crisis requires solving both crises.

This blog recommends a solution based on the full implementation of the FDR Framework.

The first step to solving the banking crisis, is disclosure of each bank's current asset and liability-level data.  Without this disclosure, market participants do not know which banks are solvent and which are not.  Without this disclosure, governments do not know which banks are solvent and which are not.

With this disclosure, not only do market participants including governments know which banks are solvent and which are not, but everyone knows how much capital the insolvent banks need to restore their solvency.

Suddenly, solving the bank solvency crisis becomes an easier task because all the knowable information is known.  The total amount of capital needed is known.

Now the question becomes where does this capital come from.

This brings us to the second step which is to solve the sovereign debt crisis.  Again, the goal is to first figure out what is an appropriate debt level for each country based on its economic capacity to carry the debt and still provide its citizens with a level of services consistent with promoting economic growth.

Suddenly, solving the sovereign crisis becomes an easier task as the total amount of capital needed is known.

Now the question becomes where does this capital come from.

There are many choices like purchasing discounted debt or forcing write-downs or issuing equity for raising capital.  With disclosure, it is much easier to determine which choice makes the most sense for each situation.  More importantly, there is reason to believe that as the capital is raised, the crisis is ended.

If any doubt remained over how closely Europe's sovereign and banking crises are intertwined, the latest contagion has laid the linkages bare. 

Shares in Italian and Spanish banks have slumped as their governments' debt costs soar; many now trade below their post-Lehman lows. But while Italy's banks are a binary bet on a euro-zone solution to its debt crisis, Spain's banking woes are more fundamental. 

 Italy's bank woes are directly linked to the sovereign-debt crisis. Until Italy found itself at the center of the market storm last week, Italian banks looked relatively strong. Between them, they have raised more than €8 billion ($11.22 billion) of capital this year and most banks now have an average core Tier 1 ratio above 8%. Italian banks also have relatively low reliance on wholesale funding. Until recently, the market's biggest concern was the sector's low profitability, reflecting high costs, low credit growth and low interest rates.

But the loss of market confidence in the sovereign has raised fresh worries. Italian banks own government bonds equivalent to 13% of total bank assets—among the highest exposure of any major economy banking system, according to the International Monetary Fund. In contrast, Spanish banks' exposure to their own government is just 6.8% of bank assets; for U.S. banks, it is 5% and the U.K. just 1.5%. The only banking system more exposed to its own government is Japan's at 24% of bank assets. 

The good news for Italian banks is that if the euro zone does succeed in addressing its sovereign-debt crisis, share prices might quickly recover. Although the turmoil in Italy partly reflects fiscal and political concerns, the biggest problem has been Germany's insistence on private-sector involvement in any fresh Greek debt deal. This has spooked investors who fear they will be forced to take losses as a first rather than a last resort. A solution that avoided that would reassure bondholders. 

But Spain's banks won't escape the spotlight so easily. The market believes the banking sector is woefully undercapitalized and the latest volatility will further hamper the initial public offerings of savings banks Bankia and Banca Civica—crucial for restoring confidence. Bankia looks particularly vulnerable as its IPO is constrained by the need to raise €4 billion without diluting its parent below 50%. 

Worse, heavy issuance of covered bonds has left Spanish banks with a shortage of collateral for future funding, according to UBS. 

To ease the pressure on Spain, a far-reaching euro-zone bailout package is needed that will pave the way for greater recognition of losses and comprehensive bank recapitalization. That could take months to arrange. Until then, Spanish banks will continue to suffer.