Andrew Ross Sorkin and the IMF's Chief change of tune on bank capital

Andrew Ross Sorkin wrote a column in the NY Time's Dealbook on how Christine Lagarde's change in roles from French bank regulator to Chief of the IMF appears to have influenced her position on the adequacy of European bank capital.

He roundly praises her for coming clean about the need for more capital and asks if she can bring the rest of the European financial regulatory community with her.

Regular readers would like to know why he thinks she should stop there.  If Bank of America has shown anything over the last few weeks, it is that the US financial regulators are every bit as guilty when it comes to hiding what is going on.  Is it credible that the 2009 stress tests missed what many analysts today believe is a $200 billion hole in BofA's balance sheet?

If he truly believed in what he wrote, he would become an advocate of the FDR Framework.

Under this framework, 21st century information technology is harnessed to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.  For banks, this is their current asset and liability-level dat which the financial regulators currently have a monopoly on.

Over the weekend, Christine Lagarde, the managing director of the International Monetary Fund, was desperately trying to back-pedal. A report had surfaced citing an internal I.M.F. document estimating that Europe’s banks were woefully short of capital — by a whopping $273.2 billion....

While Ms. Lagarde acted as if she was surprised by the number — and tried to play it down — she shouldn’t be. And in truth, she wasn’t. 

Changing her tune seems to be a theme for Ms. Lagarde, which may explain her feigned sense of shock. 

Ms. Lagarde sounded alarm bells last month about what she called the need for an “urgent recapitalization” of European banks, and was roundly criticized for it. 

“Developments this summer have indicated we are in a dangerous new phase,” she said then. Her refreshingly honest remarks had been so honest — apparently, too honest — that some bankers blamed her for further undermining confidence in European banks. 

Yes, Ms. Lagarde had broken the secret code of silence among Europe’s top bankers — a silence she herself had kept for far too long when she was a politician. 

It is this code of silence about what is actually going on with the banks that is a major source of financial instability.

As BNP Paribas Chairman Michel Pebereau observed, 'utter transparency' is needed.

Just this summer,... Ms. Lagarde was trying to will the world into believing that the French banks, the ones she oversaw as France’s Minister of Economic Affairs, Finances and Industry, and the ones which are now in the headlines every day — BNP Paribas and Société Générale, among them — were sound....

In an interview even before the results of this summer’s stress tests of European banks, she told The Economist: “As far as my banks are concerned, the French banks, I am very confident about the results; and No. 2 and probably more importantly, from what I have seen of the criteria, and the kind of tests that are applied to the 91 banks in Europe, it’s a very tough standard that is applied. And I’m saying that because I have seen here and there some, you know, allegations, little hints, and, and, various comments, analysts saying ‘Oooh, not so sure about the tests.’ Well, let’s go down to the details, the tests are really, really hard.” 

... Europe’s central bankers continue to defend the fictional stress test. 

Even as late as last week, they somehow argued that “individual disclosures of sovereign exposures were an essential component of the exercise and a great enhancement in terms of transparency” despite disbelief in the markets.

The markets disbelief was in the stress tests themselves which have been subsequently shown as not very credible.

It is an undisputed fact that the individual disclosures of sovereign exposures were a significant enhancement in terms of transparency.

We often blame United States politicians and regulators for not owning up to our economic problems until it is too late. But the Europeans have tried to keep up the fiction of their economic strength for much longer....

While the United States was injecting capital in banks, guaranteeing debt and trying to increase capital requirements, European regulators were fighting behind the scenes to keep capital requirements low.

Perhaps my memory is hazy, but I think that France injected capital into its banks and, following the example set by the US, let the banks repay this capital.

The US policy of guaranteeing financial institution debt was and is a major contributor to moral hazard.

On the other hand, this blog has argued that the US should guarantee the debt if the regulators are going to have a monopoly on the information that market participants need to assess the risk of investing in the debt.

Furthermore, when regulators say that the banks are solvent (see stress tests above), they are explicitly offering investment advice.  Given that the information monopoly makes market participants dependent on the regulators for analysis of the information, if the regulators fail to properly assess the risk, the government should pick up the loss.

Instead, European regulators, including Ms. Lagarde, jumped on the banker compensation bandwagon, which might have won her political points, but appears now to have also kept the public eye off the bigger issue: Europe’s banks were woefully undercapitalized and every regulator knew it. 

Why does anyone not think the same about US banks and what their regulators knew?

Recently, a considerable amount of attention has been focused on Bank of America and analysts' estimates that it is undercapitalized by $200 billion.  Is it believable that US regulators did not know about this capital shortfall when they conducted their 2009 stress tests?  What are we to make of the representation by the regulators that accompanied the 2009 stress tests that BoA would be adequately capitalized if it raised less than a fifth of this estimated shortfall?

... Europe’s economic problems won’t be solved until the banks — and their regulators — accept that they need more capital and a solution is reached about the structure of the European Union. (It probably has to happen in that order.) 

Actually, what has to happen first is that the banks need to disclose their current asset and liability-level data.  Market participants can use this data to determine which banks are solvent and which banks are insolvent and the amount of capital needed to restore each insolvent bank to solvency.

Some of the insolvent banks will be able retain earnings and restore their solvency.  Other banks will need to be recapitalized.  Private investors are likely to participate in this recapitalization because they will know what they are buying.  Other banks will have to be closed.

The question, of course, is now that Ms. Lagarde has broken her code of silence, can she persuade the rest of her European counterparts to come clean too?

Can she persuade the rest of the global financial regulator to come clean too?

Now that the code of silence has been broken, there is no excuse for not implementing 'utter transparency' across all financial institutions.