Saturday, October 22, 2011

IMF threat to not lend Greece more money is opportunity for Europe

According to an article in the Telegraph, the IMF is telling the European financial ministers that it will not continue to lend to Greece.

If this is true, it is extraordinarily good news as it presents the EU with the opportunity to truly address the sovereign debt and bank solvency issues.

In 2008-2009, like the US and UK, the EU elected to bailout its banking system.  The result was to change a bank solvency issue into a sovereign debt crisis.

Now, in 2011, the EU has the chance to lead the way and break from the failed policies of 2008-2009.

The time has come to force banks to recognize their losses.

Policymakers have to understand that banks recognizing losses is the safety valve in the financial system.  It is not recognizing the losses that is a primary driver of the sovereign debt crisis.  

Recognizing accounting losses will not cause the financial system to collapse.

Depositors will not run - they are covered by deposit insurance.  This deposit insurance can be enhanced by using the European Financial Stability Fund as an additional guarantor.  There is the European Central Bank to insure liquidity.

Banks can continue to originate loans that can be funded either through securities like covered bonds or by selling the loans to investors like pension funds, insurance companies and hedge funds.

Access to credit will actually be enhanced for small businesses.  Policymakers under appreciate the role that real estate plays in these loans.  Banks are senior secured lenders.  For most small businesses, the security they have to pledge is real estate.

When a real estate bubble bursts, the problem for bankers is to estimate the value of the real estate.  Not requiring the banks to write down the real estate related loans on their balance sheets prolongs the period of time in which bankers are uncertain as to the value of the real estate and thus the collateral being pledged.  It is this uncertainty that limits small businesses access to credit.

The EU should recognize the opportunity the IMF threat represents and fully utilize the safety valve that banks recognizing losses represents.

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