Thursday, October 20, 2011

Walter Bagehot provides answer to European financial crisis: "a well-run bank needs no capital"

Perhaps I am missing something, but I think that the global policymakers and financial regulators have reached the end of the road in their ability to "kick" the solvency problem into the future.

What concerns me is that they do not recognize this fact.

Instead, European policymakers and financial regulators, under pressure from the US, UK and IMF are focusing on solutions that involve kicking the solvency problem into the future.  For Europe, kicking the solvency problem into the future involves solving three simultaneous problems:
  • Restructuring Greece's debts;
  • Restoring confidence in the Eurozone banks through a re-capitalization; and
  • Increasing the firepower in the European Financial Stability Fund to protect the ability of Spain, Italy and other EU nations to access the capital markets for low cost funds. 
A recently proposed solution involved writing down Greece's debt by 50%, recapitalizing systemically important Eurozone banks with approximately 100 billion euros and using the European Financial Stability Fund to insure against restructuring losses of up to 20% on newly issued EU sovereign bonds.

According to a column by the Telegraph's Ambrose Evans-Pritchard, the problem with this and similar proposed solutions is the markets already know they will not work.

A chorus of analysts on Wednesday said the EFSF proposals are unworkable. "It is unlikely financial markets will be fooled by this for long," said Commerzbank. 
"I have no confidence in this plan whatsoever," said Hans Redeker, currency chief at Morgan Stanley. "It creates a two-tier capital market, which is dangerous. How can you insure Italian debt but not Belgian, or French debt?" 
Mr Redeker said the proposals risk setting off a chain reaction in which France loses its AAA rating, followed by Germany and the creditor core as ever greater liabilities engulf them, too. 
Morgan Stanley said European and UK banks may have to slash their loan books by €2 trillion over the next two years to boost capital and cut dependence on short-term funding. 
Lenders have already identified €775bn in cuts. The credit squeeze risks trapping Europe in near-slump next year, exacerbating the debt dynamics of Italy and Spain. 
Jacques Cailloux from RBS said the attempt to turn EFSF into a bond insurer is misguided. "In our view it will ultimately fail to restore confidence. It is very risky for euro area policy-makers to rush out some quick deal on leverage," he said, adding that the plan concentrates risk. Its "Achilles Heel" is that financial stress in Club Med states would inevitably ricochet back into Northern banks, he said. 
Mr Cailloux said coverage of just 20pc of damage is no longer enough to lure back shell-shocked investors. "It's like insurance that covers the cost of a front door rather than the full house," he said.

It is entirely possible that the EU's adopting a solution that the market has no confidence in will realize Sir Mervyn King's fears that 'we will face the worst financial crisis since the 1930s maybe ever'.

Fortunately, this is avoidable if Europe instead decides to address its solvency problems.  

There is only one way to address solvency that also is proven to restore market confidence.  This is what I previously presented as the FDR Framework's blueprint for solving the EU's sovereign debt and bank solvency crisis.

This post expands on that blueprint to include using the European Financial Stability Fund to guarantee Eurozone bank deposits and minimize the potential for a run on the Eurozone banks.

Regular readers will recall that the blueprint was based on providing disclosure to market participants.  By providing disclosure, the European policymakers and financial regulators gain two indispensable commodities.
  • They gain access to the market's analytical capabilities.  Market participants would use the disclosed information to determine who was solvent and the path back to solvency for the insolvent banks.
  • They gain restoration of confidence in the banking system and the sovereign debt market.  The involvement of the market participants in analyzing the information and the various options brings with it confidence in the solution implemented to end the solvency crisis.
Unstated, but underlying the blueprint is the fact that banks are special.  As Walter Bagehot said, "a well-run bank needs no capital."  

Please re-read Mr. Bagehot observation as it is a critical element underlying the blueprint and the solution to the European solvency crisis.

The implications of his observation are that a bank can continue to operate without being nationalized if it has a negative book equity and all of its assets are valued at levels that the bank could realistically expect to realize in an arms length negotiation with an independent third party.

This is why disclosure is of paramount importance and the key to ending the solvency crisis.

Market participants need to be in a position where they can monitor the current detailed assets, liabilities and off-balance sheet exposures of a bank to confirm that the bank is well-run going forward!

If market participants can do this, they can assess the risk of the bank and adjust the amount and price of their exposure accordingly.

Furthermore, until a bank is closed by the regulator in their host country, it can continue to make loans.

How will a bank fund these loans? Eurozone banks should also be able to tap the capital markets to fund these loans.  For example, when investors can monitor the loans backing a covered bond (they will be able to do so as part of the detailed disclosure by the bank), there should be much more of an appetite for these bonds.  Alternatively, they can sell the loans to investors (pensions, insurers, hedge funds to mention a few).

The bottom-line is that a long period of negative book capital does not mean that banks cannot support the lending needs of the economy. 

Finally, in Europe there is the issue of the European Central Bank's exposures to assets that are going to be repriced.  The Eurozone banks should make the ECB whole for any losses on securities that they pledged to the bank.  

As for losses on any sovereign debt the ECB purchased, it needs to be realized that central banks are unique because they have no cost for carrying the sovereign debt nor do they pay taxes.  As a result, they only experience a loss if the interest paid on the debt plus the principal repaid on the debt is less than their purchase price for the debt.  This loss should be covered by the European Financial Stability Fund.

"How to implement" the blueprint:
  • European regulators should disclose what they know about each bank so that market participants can assess the solvency of each bank and the path back to solvency for the insolvent banks.  
  • Europe should require that its banks disclose their current detailed asset/liability data going forward through a conflict of interest free data warehouse so that market discipline can be brought to bear and keep the banks' risk level in check.
  • Europe should use the EFSF to guarantee the deposits at all of the EU banks - this is done to prevent a run on the EU banks.  It is also the most efficient way to leverage up the EFSF funds.
  • Europe should implement the great credit restructuring.  This includes writing down both the sovereign debt and any other bad debts (like residential real estate) that the banks hold to a price they could realistically expect to receive from an independent third party.  These write-downs are necessary to clean up the banks' balance sheets. 
  • The banks should be required over time to recapitalize their balance sheets.  This can be done through retained earnings and the sale of equity in the capital markets.  It is important to reiterate that these banks will be an attractive investment as investors will be able to assess what they are buying.  In fact, with disclosure, banks will not be able to take the level of risks that they took leading up to the financial crisis and they will once again be viewed as long-term, stable, conservative investments.
Please note that the intent of the blueprint is to restore solvency to the Eurozone financial system.  The intent is not to resolve the economic imbalances that exist between countries in the Eurozone.  If the blueprint is adopted, it will provide the time and financial market stability necessary for those discussions to take place.

Considering the alternative solutions that are out there, the blueprint moves the Eurozone as close to an economically optimal outcome as possible while staying within the constraints of the politically possible.

Finally, I expect that the banking industry's Opacity Protection Team will vigorously object to the blueprint as the blueprint is based on detailed disclosure.  

They will make unsubstantiated claims like the banks won't be able to make loans (the issue is not origination of the loans, but where the loans are held), depositors require banks to have positive book capital (depositors care that their accounts are insured so they can get their money back), and equity and debt investors require banks to have positive book capital (with detailed disclosure, investors, like other banks, will be able to do a better job of assessing the risk of a bank and low risk banks can expect to have greater access at lower cost to investor funds).

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