Sunday, September 4, 2011

Global economy faces a 'threatening downward spiral' that only disclosure can stop

Prior to the credit crisis, your humble blogger publicly stated that the global economy faced a downward spiral with no logical stopping point unless disclosure was adopted.

Ambrose Evans-Pritchard reports in a Telegraph article that the IMF's Christine Lagarde agrees with this prediction.
Christine Lagarde, the IMF's managing-director, said the outlook had darkened suddenly over the summer. 
"There has been a clear crisis of confidence that has seriously aggravated the situation. Measures need to be taken to ensure that this vicious circle is broken," she said.
The crisis of confidence begins in the financial sector.  No market participant can figure out which banks are solvent and which are not.

When banks cannot figure out if their competitors are solvent, they do not lend in the interbank market.  The chief executive of ABN Amro reported that liquidity has essentially disappeared in the interbank market for loans of 6 months (see here).
"The spectrum of policies available is narrower because a lot of ammunition was used in 2009. But if governments, institutions and central banks work together, we'll avoid recession," she told Der Spiegel.
Translation:  a wide-spread bail out of the banks is no longer a policy option.

The question is what options are still available?  At the top of the list is requiring banks to disclose their current asset and liability-level data.

With this data, market participants including competitor banks will be able to determine which banks are solvent and which are insolvent.

Equally importantly, market participants will know how much capital each insolvent bank needs to return to solvency.  Some of these banks will be able to raise this capital by retaining 100% of their earnings.  Others will require an injection of capital.  Still others will not be able to return to solvency and will need to be closed.

Regardless of what happens to any individual bank, what only disclosure can and will do is restore confidence and ensure that the vicious cycle is broken.

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