Thursday, October 6, 2011

Its a solvency crisis, not a liquidity crisis

By treating a solvency crisis as a liquidity crisis, have global financial policymakers set the global economy up for what the Bank of England's Mervyn King fears is "the most serious financial crisis at least since the 1930s if not ever?"


This is the unmistakable conclusion when you realize that four years after the solvency crisis began, global market participants still do not know which banks are solvent and which banks are insolvent.

In Europe this month, the questions are:

  • will it take 200 billion or 2 trillion euros to fill the hole in the bank balance sheets; and 
  • will market participants believe that the solvency issue is ended regardless of which number European policymakers choose.

It is the second question that is the more difficult because if market participants do not believe the solvency issue is ended, like the original bank bailouts, all these new bank bailouts will do is buy some time.

Fortunately, there is a way to get market participants to believe in the adequacy of the number.

Regular readers know that

  • requiring banks to disclose their current asset and liability-level data would allow market participants to determine which banks are solvent and which banks are insolvent.  

  • More importantly, it would also allow market participants to determine how much capital is needed by each bank and in total to end the solvency crisis and believe that this amount of capital is sufficient.  

  • Even more importantly, it would restore market participants' confidence so that they could voluntarily be the source of capital rather than government balance sheets.
  • Perhaps most importantly, it would also result in debt being written down to a level where the borrower could service the debt (this occurs as part of the process of assessing a bank's solvency as solvency is defined as the market value of the bank's assets minus the book value of its liabilities).

Yet, here we are four years into the solvency crisis and banks are still not required to disclose this data and work has not begun on a data warehouse so that all market participants can access this information.

Now, we have European policymakers having to make a choice.  Do they require banks to disclose their current assets and liability-level data and involve market participants in ending the solvency crisis or Do they listen to Wall Street and use the taxpayers' money to bailout the banks.

Given the lack of progress on disclosure, the odds heavily favor bailing out the banks and a continuation of the most serious financial crisis since the 1930s if not ever.


Quote from Mervyn King

The situation in 2008/9 around the world was so much easier than it is today. Those measures taken then did not solve the underlying problems.This is undoubtedly the biggest financial crisis the world has ever faced.
This is exactly the point I have been making since the beginning of the financial crisis.

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