The Financial Times would like to "eradicate the fear in Europe's banks"

A column by the editors of the Financial Times looks at efforts to eradicate the fear in Europe's banks.

It is one thing if your humble blogger says that investor fear is a direct result of the opacity of bank balance sheets.  I have been saying this since the beginning of the financial crisis on August 9, 2007.

It is entirely another when the Financial Times directly and permanently links investor fear to the opacity of bank balance sheets.

As investors again fear to tread amid the holes of unknown depth that riddle Europe’s banking system, policymakers have finally regained their resolve. Better late than never: the efforts now being made to probe and fill the capital needs of banks are welcome news....

Now, across the European Union, banks are under strain, with a particularly vicious dynamic in the eurozone. Troubled sovereign debt weighs on banks’ balance sheets and lending, which in turn threatens growth and sovereign creditworthiness. 

Everyone knows that there are unrealised losses in European banks, but nobody knows how big they are and who will bear them. Investors rightly fear about their potential exposure – not a good incentive to ensure uninterrupted funding for banks’ credit to households and businesses. 

The [European Banking Authority] must therefore carry out its plans for new stress tests without delay. This can only be the first step. Once holes are found and measured, they must be promptly filled in a co-ordinated EU-wide action: contagion is now European if not global. A mooted 9 per cent tier one capital threshold makes sense. While there is nothing magic about that number, it ensures a sufficient common minimum.... 

This prescription for action works only if you assume that investors will trust the results of the European Banking Authority's stress test.  Why should they given that earlier tests saw banks pass (Dexia, Bank of Ireland Plc and Allied Irish Bank Plc) that were subsequently nationalized within 90 days?

The only way that investors are going to trust that all the holes have been found and properly measured is if each bank's current asset and liability-level data is disclosed and the investors can do the analysis for themselves.

The crisis is also an opportunity to undo the EU’s mistake of treating private banks’ bondholders with more respect than taxpayers.

This mistake is the result of each country's financial regulators having access to information that is not made available to all market participants. The financial regulators have access to each bank's current asset and liability-level data.  Other market participants do not.

As a result, the other market participants are dependent on the financial regulators to analyse this data and properly assess and communicate to the market the risk of each bank.  This dependency on the financial regulators creates a moral obligation to bail out private bondholders.  After all, why should they incur losses when the financial regulators are saying the bank is solvent?

If we are going to make private bondholders responsible for losses on their investments, we have an obligation to provide them with the current asset and liability-level data so they can assess the risk of their exposure.

Most banks should be able to raise capital privately or by limiting dividends and bonuses....

Ireland, Spain and Greece have shown that banks are not able to raise capital privately when there is doubt about their solvency.

The only way banks are going to be able to tap the capital markets is if they disclose their current asset and liability-level data.  With this data, market participants can assess whether the bank is solvent or insolvent (where solvency is a function of the relationship between the market value of a bank's assets and the book value of its liabilities).

If solvent, private investors will rush to invest.

If insolvent, private investors will look to see if the bank's franchise provides it with the capacity to earn its way back to solvency - Security Pacific is an example of this as it was insolvent from loans made to less developed countries.  Where the banking franchise has earning capability, private investors will invest.

The other insolvent banks can be recapitalized through payment of dividends and bonuses in stock or bailouts by the host government.  Alternatively, the host government might decide to close the banks down and sell off their assets.

The collapse of Lehman Brothers in 2008 brought the world’s financial system close to meltdown. It is time to show the right lessons were learnt.

The right lesson in particular is the way to eradicate market participants' fear in banks is to require each bank to disclose its current asset and liability-level data.

Your humble blogger looks forward to working with the EU financial regulators and setting up a data warehouse that will provide all market participants access for free to each bank's current asset and liability-level data.