Only way to break solvency crisis cycle is disclosure

In his Telegraph column, Jeremy Warner provides one of the best summaries of a) the solvency crisis cycle and b) the regulatory response.

Thankfully, the FSA has stayed clear of the state of denial that exists among some eurozone regulators this time around, but the narrative is exactly the same as it was back [in 2008]. 

There’s nothing wrong with the big European banks which are perfectly solvent, regulators insist, but the short-sellers, by crunching the share price, threaten a self fulfilling prophecy by creating a panic which causes a run and thereby makes the banking system freeze over anew. 

Regular readers know that under the FDR Framework, regulators are never put into a position where they would try to convince the markets that the banks are solvent.

The first reason regulators would never try to do this is because market participants have access to all the current asset and liability-level data for each bank that they can independently analyze or hire an expert to analyze for them.  There is no reason for regulators to put their credibility on the line when they know that market participants can and will verify the regulators' claim that the banks are solvent.

The second reason regulators would never try to do this is because market participants have an incentive to analyze the current asset and liability-level data since they are responsible for any gain or loss on their exposure to the banks.

As I say, exactly the same arguments were used back in 2008, when the Financial Services Authority went so far as to put out a statement saying that HBOS was completely solvent and was the target of malicious scaremongering. A little while later, the Government admitted the bank was bust and recapitalised it with billions of pounds of taxpayers money. 

The reality is that the downward spiral in European bank stocks has very little to do with short-selling, and everything to do with the fundamentals of the eurozone debt crisis, which European policy makers would prefer to deny rather than face up to.... 

But just because this time the FSA has turned its back on the French overreaction doesn’t mean everything is fine and dandy over here. Shares in Royal Bank of Scotland Lloyds Banking Group are now lower, by a very substantial order of magnitude, than they were when the taxpayer was forced to bail them out. Markets don’t seem to have much confidence in the Chancellor’s insistence that our own banks are fully prepared for the worst. 

In the absence of disclosure, why should markets have much confidence?

It is far more prudent to adopt the adage:  fool me once shame on you; fool me twice shame on me.  The government has already shown with HBOS that they are willing to represent an insolvent bank as solvent.

The problem is this: by causing a deep recession and spiralling public debts, the original banking crisis transmogrified into a sovereign debt crisis, which because sovereign bonds are a core asset for all large banks, now threatens to transmogrify back into a second banking crisis and another deep recession. 

There’s a remorseless, doomsday circularity about it all which policy makers seem quite incapable of addressing.

Policy makers are unwilling to address it because the only solution to end the doomsday circularity is for regulators to give up their information monopoly and ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

By providing this disclosure, market participants will be able to answer the question of who is solvent and who is insolvent.

Surely they’ve learned the lessons of Lehman’s, and now realise that to sort out these rolling debt crises for good, some form of internationally agreed burden sharing between creditors and debtors has to imposed?

Burden sharing is only one way to address insolvency.

This blog has frequently brought up another way that was exemplified by Security Pacific.  It was publicly known that Sec Pac was insolvent because of its loans to less developed countries, but market participants were willing to let it continue operating because it had a business model that would allow it to earn its way back to solvency.

What made the Sec Pac solvency approach workable is that disclosure allowed the market to know how much capital Sec Pac needed and to track Sec Pac's progress to raise this capital either through retention of earnings or equity issuance.