Tuesday, October 18, 2011

Mervyn King: Four years into the crisis it is surely time to accept the underlying problem is solvency, not liquidity

Bank of England Governor Mervyn King confirms we are dealing with a solvency crisis and embraces the recommendation under the FDR Framework for disclosure by banks that your humble blogger has been making.

According to an article in the Telegraph, he observed
All of the emergency stimulus measures employed to support European banks and the eurozone had simply “bought time” for world leaders to address that fundamental imbalance, Sir Mervyn said in a speech in Liverpool last night. 
“So far, that time has not been used to deal with the underlying imbalances, or the weaknesses in bank and sovereign balance sheets,” he said. “Time is running out [to prevent the greatest economic crisis since the 1930s or of all time].”
According to another article in the Telegraph,
[F]ar more urgent is how we deal with the crisis of confidence in some banks and sovereigns. 
Here the Bank of England Governor had a clear message for the eurozone. "A transparent recognition of losses and a substantial injection of additional capital are necessary to restore market confidence." 
Four years into the crisis, said Sir Mervyn, it was "surely time to accept that the underlying problem is one of solvency, not liquidity". This goes for banks and countries, added Sir Mervyn. 
A round of recapitalisations in October 2008 was inadequate, he believes, especially on the Continent. And he's right.
As this blog has repeatedly said, the only way to know if a capital injection is adequate is if there is disclosure by each bank of its current asset and liability-level data, including off-balance sheet exposures.  With this data, market participants can verify that all the bank losses have been recognized.  With this data, market participants can assess how much, if any, capital a bank needs.

Where this blog differs from Mr. King is over the timing of recapitalizing the banks.

Your humble blogger believes that so long as banks continue to disclose their current asset and liability-level data, they do not have to recapitalize immediately.  Instead, they can recapitalize over time through retained earnings and stock issuance.  While the banks are recapitalizing, either market discipline or regulatory persuasion will act as a restraint on the banks increasing their risk profile.

Not recapitalizing immediately should have no impact on the ability of banks to make all the loans necessary to support a growing economy.  While it will impact their ability to hold the loans they generate, this is not a problem.  There are plenty of buyers of these loans in the capital markets (insurers, pension funds, hedge funds to mention a few).


From an article in the Guardian,
Four years into the financial crisis, King said it was time to accept that the underlying problem was solvency of banks and countries. "Of course, the provision of additional liquidity support to countries or institutions in trouble can buy time. But that time will prove valuable only if it is used to tackle the underlying problem."
King said that the recapitalisation of banks in continental Europe in October 2008 had been inadequate, noting that the underlying problems of excessive debt had not gone away. "As a result, markets are now posing new questions about the solvency of banks, and indeed of governments themselves."

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