Saturday, October 1, 2011

Leading European banks refusing to increase capital buffers confirms need for implementing FDR Framework

According to a Telegraph article, leading European banks are refusing to increase their capital buffers and are therefore putting the plan to rescue the EU at risk.

This negotiating by the banks with the European policy makers and financial regulators confirms the need for the EU to immediately implement the FDR Framework with its current asset and liability-level disclosure requirement for banks.

Under the FDR Framework, these negotiations are replaced with market discipline.

Banks that are not adequately capitalized will find themselves with less access to funding and a higher cost for the funds they can access.  This market discipline, with its direct impact on the bottom line and the bank's stock price, should provide sufficient incentive for banks to increase their capital buffers without regulatory encouragement.
Senior sources said that leading European lenders are pushing back against international efforts to force them to recapitalise. 
Instead, they are insisting their problems are solely to do with liquidity and are calling on the European Central Bank (ECB) to flood the system with massive amounts of two-year funding to see them through the crisis. 
The liquidity problem the European banks are facing is a symptom of their solvency problem.

Without disclosure of each bank's current assets and liability-level information, market participants cannot tell who is solvent and who is insolvent.  Rather than wait and find out if their investment is in a solvent or insolvent bank, they have an incentive to withdraw their money from all the European banks.  This "run" on the European banks is causing the banks to have liquidity problems.

In 2008, the central banks, including the Fed, ECB and BoE, listened to the banks and addressed the year-old solvency crisis by injecting massive amounts of funding.  This policy failed to end the solvency crisis as shown by the current concern over the European bank solvency.

This policy was also one of the foundation blocks for creating the moral hazard of Too Big to Fail.
... Recapitalising the banks is central to a three-pronged strategy to restore market confidence in Europe...
Regular readers know that without disclosure of each bank's current asset and liability-level information, European policy makers and financial regulators will not be able to restore market confidence.

Without this information, market participants cannot do their own analysis to answer the question of who is solvent and who is insolvent.  If market participants cannot independently verify the answer to this question, it is impossible to restore market confidence.
Europe’s banks want the European Financial Stability Facility (EFSF) bail-out scheme’s firepower increased to more than €440bn, possibly by using the funds as a “first-loss” guarantee on ECB or private sector purchases of sovereign debt; the ECB to provide banks with two-year funding; and an agreement struck for a credible Greek rescue plan. 
Insiders said the banks would be willing to increase the “haircut” on their holdings of Greek sovereign debt from the agreed 21pc to 50pc so long as the rescue package was convincing enough to firebreak the crisis at Athens. 
They would only consider a recapitalisation if it was imposed across Europe as a form of “backstop” facility on which the banks could draw if the crisis escalated by engulfing Italy. 
One top banking source said: “The governments don’t want to put money into the banks. They see that as a last, last resort.” 
Europe’s banks claim that raising capital privately is almost impossible due to new Basel regulations on liquidity that are preventing them from increasing lending. As a result, they cannot justify the cost of raising new capital. 
Rather than debunk each of the banks' arguments one at a time, let me just say that each argument supports the need for Europe's policy makers and financial regulators to immediately implement the disclosure requirements of the FDR Framework.

For example, the banks offer to write-down their Greek debt to existing market prices if there is a big enough rescue package.  Under the FDR Framework, whether or not banks formally write-down their Greek debt, market participants would mark Greek, Italian, Irish, Spanish and Portugese debt to existing market prices.  They would do so because assessing the risk and determining the solvency of each bank requires comparing the market value of its assets with the book value of its liabilities.

Since market participants have already marked the assets to market, the banks negotiation with the regulators and policy makers is effectively ended and rescuing the EU is no longer held hostage by the banking industry.

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