The FDR Framework provides a roadmap for addressing the European solvency crisis

Both Ed Harrison on Credit Writedowns (cross-posted on NakedCapitalism) and Larry Summers in a Financial Times column (cross-posted on a Reuters blog) called for a "credible solution" for Europe's solvency crisis.

Fortunately, the FDR Framework provides a credible roadmap for addressing the European solvency crisis.  

It addresses the solvency crisis by requiring banks to disclose all their current asset and liability details to all market participants thereby engaging the market's analytical abilities to determine who is solvent and who is insolvent.  Subsequently, policymakers can work with the market to develop a solution for the insolvent banks and sovereigns and then implementing the solution.

Going through these steps takes time.

Fortunately, by disclosing the facts now and engaging the market's analytical abilities, the roadmap eliminates uncertainty as to who is solvent and who is insolvent and buys a significant amount of time for addressing the issue.

Right now, markets are guessing about who is solvent and who is insolvent  and, if insolvent, by how much and in the process guessing if there are adequate resources to protect depositors from losses.  This has spurred the ongoing runs on the European banks and sovereigns (see here).

With the uncertainty of who is solvent eliminated, markets can see if there are adequate resources, from the host European country or from vehicles like the European Financial Stability Fund, to protect the depositors from losses.  If there are, the ongoing runs will stop so long as the market thinks the solvency issue is being addressed.

Eliminating the uncertainty over who is solvent also eliminates the fear of contagion.  Part of assessing solvency is looking at each bank's exposures and the potential impact of a restructuring on these exposures.

Eliminating the uncertainty over who is solvent also eliminates financial instability caused by brinksmanship in sovereign debt restructuring.  For example, Greece could not use a threat of default and the uncertain consequences of contagion as leverage for additional funds.  Similarly, Germany might be much more willing to help Greece if it were well known to the German public that their banks would be insolvent if Greece was not supported.

What remains to be determined is how to handle the insolvent financial institutions and sovereigns.  Market participants can help in the determination of which of these can regain its solvency on its own, which of these will need to access private capital and which of these will need to be restructured.

Regular readers recall that under the FDR Framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  Market participants are given an incentive to use this data to assess the risk and reward of an investment because they are responsible for any gains or losses on the investment.

Let's look at how this translates into a roadmap for addressing the European solvency crisis:

• First, European policymakers and regulators must make a statement describing the current condition of each of the 90 banks that were stress tested.  Regulators should not simply restate the results of the stress tests, but rather state here is the bank's current condition accompanied by disclosure of the hard facts sufficient to support this statement of condition.  For an example of what this statement should look like, policymakers and regulators might want to refer to the recent disclosure by Societe Generale in its bid to win back market confidence.

• The reason for issuing this statement is to anchor the market to the current facts about the European banks.  This replaces what is happening now where market participant's assumptions are not constrained by these facts.  In a leveraged financial system, when fear of contagion takes over, it always justifies a pre-emptive run on the banks as there is never enough equity in the system.

• Second, European policymakers and regulators must promise to provide market participants what the Chairman of BNP Paribas called 'utter transparency'.  This involves creating a data warehouse with each bank's current asset and liability-level data.  When finished, this data will be kept current and will be made available at no cost to all market participants.

• The reason for building the data warehouse is that over the three to four years it will take to build it provides the credibility for the policymakers' and regulators' statements about the condition of each bank.  Market participants know this granular data would not be released if it were going to show that these statements of condition were untrue.

This roadmap has several advantages.

• It recognizes the need to reassure the markets now by ending uncertainty about the condition of each bank and sovereign.

• It engages the market's analytical capabilities for thinking through how to address bank and sovereign solvency starting from a common point of reference.  This is critically important because it is this activity that allows market participants to accept the solution that emerges as ending the solvency crisis.

• It restores confidence going forward because market participants have access to the granular level information they need to assess the risk and reward of investing in each country's banks and the sovereign.

Professor Summers observed,

At every stage from the first signs of trouble in Greece to the spread of problems to Portugal and Ireland, to the recognition of Greece’s inability to pay its debts in full, to the rise of debt spreads in Spain and Italy, the authorities have ... done just enough beyond euro-orthodoxy to avoid an imminent collapse, but never enough to establish a sound foundation for a resumption of confidence....

The roadmap based on the FDR Framework establishes a sound foundation for the resumption of confidence in both the European banks and sovereigns.

The process has taken its toll on policymakers’ credibility.  As I warned European friends quite some time ago, authorities who assert in the face of all evidence that Greece can service on time 100 percent of its debts will have little credibility when they later assert that the fundamentals are sound in Spain and Italy, even if their view is a reasonable one.  

After the spectacle of stress tests that treat assets where credit default swaps exceed 500 basis points as riskless, how can markets do otherwise than to ignore regulators assertions about the solvency of certain key financial institutions. 

Thank you Larry for warning the European financial community about the potential to lose credibility.  This is particularly true when policymakers engage in stress tests and partial recapitalizations without meeting the disclosure standards under the FDR Framework.

I presented a similar warning to the global financial community prior to the onset of the financial crisis (see December 2007 and February 2008).  In doing so, I also outlined the reason the crisis was about to occur and the solution to resolving it which is reflected in the roadmap based on the FDR Framework.

The roadmap increases the policymakers' credibility.  It engages the market participants in the determination of who is solvent and who is not.  More importantly, it engages the market participants in the determination of how to handle those key financial institutions that are not solvent.

In the future after the data warehouse is operating, it eliminates any need for regulators publishing the results of a stress test again and the potential for loss of credibility.

A continuation of the grudging incrementalism of the last two years risks catastrophe, as what was a task of defining the parameters of too big to fail becomes a challenge of figuring out what to do when key insolvent debtors are too large to save.  

By taking the bold step of following the roadmap based on the FDR Framework, European policymakers will firmly address the issue.

Market participants know that to end the solvency crisis requires their involvement from knowing what the facts are to their using these facts to analyze alternative solutions to their input to policymakers in the selection of a the solution that ends the problem.

As Mr. Harrison said,

It was only when the US banks were partially recapitalised in 2009 after the stress tests that the panic ended. And even so, partial recapitalisation means nagging doubts about the health of some institutions like Bank of America persist. If the US economy double dips, you should expect those doubts to increase and the doubts to spread to other institutions.

Simply bailing out financial institutions and sovereigns without the accompanying disclosure required under the FDR Framework does not tell market participants if they are solvent or not and therefore does not end the crisis.