IMF's Lagarde calls for urgent recapitalization of Europe's banks

A Bloomberg article reports that in her speech at the Jackson Hole conference, IMF chief Christine Lagarde called for the urgent recapitalization of Europe's banks.

With this speech, she acknowledges that Europe's banks are still facing the solvency crisis that Mervyn King identified four years ago.

Regular readers know that the key to ending a solvency crisis and the risk of contagion is to address the issue of who is solvent and who is insolvent by using disclosure of each financial institution's current asset and liability-level data.

• It is only with this data that market participants can determine if the market value of a financial institution's assets exceeds the book value of its liabilities (the definition of solvency). 

• It is only with this data that market participants know just how insolvent an insolvent bank might be.

• It is only with this data that the "chains of contagion" are permanently severed as market participants use this data to assess the risk of each financial institution and adjust the price and amount of their exposure.  Market participant will limit the size of their exposure based on their analysis of the risk of losing their investment and their capacity to absorb this loss.

Simply adding capital without disclosure does not mean that a financial institution is solvent.

In 2008 and 2009, policymakers injected capital into the banks without also providing current asset and liability-level disclosure.  Now, in 2011, the solvency of these same banks is once again being questioned.

Bank of America illustrates this point.  Despite raising all the equity required under the 2009 stress tests and $5 billion from Warren Buffett, some analysts believe that BofA still needs to raise an additional $100 - $200 billion to cover the difference between the market value of its assets and the book value of its liabilities.

The time has come to address the solvency crisis and fix the contagion problem once and for all.  First, policymakers must require disclosure of each financial institution's current asset and liability-level data.  Second, only after this data has been made available to market participants should a decision be made as to how to recapitalize or close the insolvent institutions.

... European banks should be forced to build up their capital to prevent the continent’s debt crisis from infecting more countries. 

Bolstering banks’ balance sheets “is key to cutting the chains of contagion,” Lagarde said today in remarks at the Federal Reserve’s annual forum in Jackson Hole, Wyoming. 

Without an “urgent” recapitalization, “we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis.” 

Lagarde, a former French finance minister who took the helm at the Washington-based IMF in July, said recapitalization should be “substantial” and called a mandatory move “the most efficient solution.” Banks should look for funds in the markets first and seek public money if necessary, including from the European bailout fund, she said.

Disclosure of current asset and liability-level data is the most efficient solution because it answers the question of who is solvent and who is insolvent.  Private investors are not going to invest without knowing if a financial institution is solvent or not.

The stress tests on 90 European banks published on July 15 showed eight lenders had a combined 2.5 billion-euro ($3.6 billion) capital shortfall, failing to ease concern that many of them remain vulnerable to a potential sovereign default. European lenders are dependent on aid from the European Central Bank, including unlimited loans that are keeping many banks in Greece, Portugal, Italy and Spain solvent. 

ECB President Jean-Claude Trichet today dismissed any idea that Europe could face a liquidity shortage, saying efforts to combat the financial crisis will prevent such an outcome.

“The idea that we could have a liquidity problem in Europe” is “plain wrong because of these non-standard measures we have taken,” Trichet said in Jackson Hole. 

The ECB, which is also buying sovereign debt from some euro countries including Portugal, is acting in part because governments have yet to ratify a plan to extend the scope of the 440-billion euro rescue facility to allow it to buy bonds and inject capital into banks. 

The fact of the matter is that the ECB, the BoE and the Fed still have the programs in place to provide the financial markets with liquidity during the time it takes to implement disclosure of each financial institution's current asset and liability-level data.

There is plenty of time to implement a solution to the solvency crisis and contagion problem that the market will find credible.

What there is no more time for are more of the same policies that governments can no longer afford and that have not ended the solvency crisis and contagion problem.