Thursday, December 1, 2011

Central bankers buy time, but will it be used to implement a simple solution to the global solvency crisis

Gee, we appear to have turned back to 2008 when the question was:  which banks are solvent and which are not?  

Now, as then, the answer is to provide ultra transparency so the market can figure it out.  Ultra transparency for banks is to require them to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Then divide the insolvent banks into two categories:  those with a franchise where they can eventually earn their way back to solvency and those who cannot.

It actually is a simple solution because it recognizes that insolvent banks can operate for years so long as their deposits are guaranteed and the central bank is willing to lend against good collateral.

One of the benefits of ultra transparency is that it naturally expands the pool of good collateral that can be pledged to a central bank to include everything on a bank's balance sheet.  By definition, the market prices all the assets (including loans and securities) on the balance sheet and the central bank can lend against these market values.

In Europe, there is the sovereign debt issue that raises doubts about the deposit guarantees.  This can be solved by having the European Financial Stability Fund (EFSF) act as a backstop to the sovereigns.

Ultra transparency on an on-going basis is needed so that insolvent banks do not gamble on redemption (a lesson we learned from the US Savings and Loan crisis).

Ultra transparency also forces the issue of dealing with the troubled assets.  Market participants know and have applied a discount to the trouble assets.  As a result, banks can write them down to levels where the borrower can afford to service the debt obligation.

Finally, writing down the troubled assets to levels the borrower can afford also ends the Eurozone sovereign crisis.  By definition, the sovereigns will be able to afford the written down debt level.

The issue the sovereign will face moving forward is trying to access the capital markets for increased funding (as opposed to rolling over their existing debt).  To the extent that the sovereign wants to raise additional debt, it will have to adopt policies that show it is capable of repaying the new debt.

This simple solution has many advantages including:  
  • It relies on market discipline.  No one is going to force an investor to buy the new sovereign debt, so the sovereign really is going to have to adopt policies that show it can service any increases in its debt level;
  • It does not require other countries to backstop the sovereign or oversee the sovereign to be sure it is adhering to budgetary restraints.  The market does this instead.

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