Wednesday, September 21, 2011

Did the IMF endorse the FDR Framework's roadmap for addressing Europe's solvency crisis?

In his Telegraph column, Jeremy Warner analyzes not only what the IMF said in its twice yearly Global Financial Stability Report but what its message to European policymakers was.

Independent of this report, I posted a roadmap based on the FDR Framework for addressing Europe's solvency crisis.

It is clear from what the IMF said and its message to European policymakers that it would support European policymakers adopting the roadmap and addressing Europe's solvency crisis.

Most International Monetary Fund reports are necessarily the result of compromise and negotiation. Rarely is the IMF allowed by its nation shareholders to tell it exactly as it sees it. 
So the warning in the IMF's latest "Global Financial Stability Report" that European Union banks face a possible capital shortfall of €200bn to €300bn as a result of the eurozone sovereign debt crisis comes as quite an eye opener. 
European governments will have fought this assessment tooth and nail, for not only does it seem to add fuel to what is already a raging panic around the solvency of the European banking system, it also provides some indication of quite how much more public money is going to be required for recapitalisation. 
In the absence of asset and liability-level disclosure as recommended under the FDR Framework, it is necessarily public money that is needed for recapitalization.

After all, what private investors would take on the risk of losing their investment in a financial institution where they do not have the data necessary to evaluate if the financial institution will be solvent after their investment?
Banks were stress tested by European banking regulators against bad debt risk less than three months ago, and with a few notable exceptions, were found to be broadly sound....
But these stress test results did not restore market confidence as, for example, the assumptions used in the test were immediately criticized.  One of the criticisms was that the test did not adequately cover the possibility of one or more sovereign defaults/restructurings.

Regular readers know that by definition stress tests do not restore market confidence.  Stress tests are run by regulators.  The source of market confidence is market participants using granular level data from the banks to run their own stress tests.  It is the results of these stress tests that market participants believe.
The IMF is at pains to stress that the €200-300bn cited is an estimate of the increased sovereign credit risk in the EU banking system, not of the extra capital needed by banks as such. None the less, it is the IMF's best guess at the size of capital at risk. This is, if you like, the IMF's assessment of the unrealised losses in the European banking system as a result of the sovereign debt crisis. 
Of course, some of this risk may already have been written off or provided for. The point is that we just don't know, as there is no transparency in the system or commonly applied method of accounting for such assets.  
Since before the financial crisis began on August 9, 2007, I have been advocating for transparency in the global financial system.  This includes both the regulated banking system and the shadow banking system.

The reason I have done so is with transparency (disclosure of all the useful, relevant information in an appropriate, timely manner) we could know.

There is no reason given the availability of 21st century information technology that it should be a mystery if a bank has written off or provided for a sovereign credit.
Small wonder that many European banks can no longer access private funding markets.
Who would want to put funds into a bank if they cannot assess the risk of loss?  This assessment can either be done by the market participant or by using trusted independent third parties.
Small wonder too that European governments are so alarmed at this assessment, statement of the bleedin' obvious though it might be. Another round of bank bailouts so soon after the last one is anathma to most Europeans, worse, in some respects than the idea of bailing out sovereign nations directly. 
Yet if this crisis is ever to be resolved, the IMF is surely right in asserting that recapitalisation of the banks is one of the first things that needs to happen.
But not until after there is transparency so that the market can assess whether the recapitalizations actually restored solvency or not. 
Most people will find the idea that more than four years after the banking crisis began, the banking system continues to require squillions of public money almost beyond belief. 
It was reasonable to assume that the balance sheet problems of most banks had been "cured". Plainly they have not. Indeed the process seems barely to have begun....
Actually, assuming that the bank balance sheet problems had been "cured" is just repeating the assumption that bank balance sheets were not risky prior to the beginning of the financial crisis in 2007.

Just because global financial regulators have been saying the problem has been fixed does not mean it has been fixed.
As the IMF Stability Report warns, "Time is running out to address existing vulnerabilities. The set of policy choices that are both economically viable and politically feasible is shrinking as the crisis shifts into a new, more political phase"....
Which is where the roadmap based on the FDR Framework comes in.  It is economically viable as it limits the amount of government money needed to address solvency in the European banks and sovereigns.  It is politically feasible because it addresses the solvency crisis in a way that will result in a credible solution.

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