Debt crisis is causing a dangerous dependence on central banks

In a Bloomberg article, the Bank of England's Mervyn King effectively points out that the solution to a solvency crisis is not massive amount of central bank liquidity.

Regular readers know that your humble blogger has been saying this since the beginning of the credit crisis.

The solution to a solvency crisis, and it was proven by the FDR Administration in 1933, is based on ultra transparency.  It involves three simultaneous steps:

• Make the banks recognize the losses currently hidden on and off their balance sheets (this ends the mis-pricing of assets in the real economy caused by 'extend and pretend' activities);

• Have the governments guarantee each bank's deposits and unsecured liabilities (this lets the banks continue in operation providing credit to the economy even with negative book equity); and

• Require the banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details (this restores confidence in the market as participants know that all losses have been recognized and they can exert discipline to keep the banks from gambling on redemption).

What Mr. King identified in the article is the ongoing collapse of confidence by investors is leading to a dangerous over-reliance by banks on funding from the central banks.

Mervyn King, vice chairman of the European Systemic Risk Board, said Europe’s sovereign debt crisis is threatening to hurt the real economy and the outlook for financial stability has worsened. 

The damage to the real economy is caused by requiring the real economy to absorb losses from the financial excesses that have occurred rather than the banks.

It is a primary role of the banking system to act as a safety valve and absorb losses on financial excesses so that the real economy is not hurt.

Growth prospects “have deteriorated” since September, King, who is also governor of the Bank of England, said at a briefing hosted by theEuropean Central Bank in Frankfurt yesterday. “Investors lack confidence to continue to provide normal levels of funding. Dependence on central banks has risen.”

Why should investors have confidence in the banking system?  Because banks are not required to provide ultra transparency, there is no way for any market participant, including banking competitors, to know who is solvent and who is insolvent.

The solvency crisis began on August 9, 2007 and since that time the global financial regulators and policymakers have done absolutely nothing to address it.  The losses that existed in the global banking system are still there.  It is the cover-up of these losses by the regulators and bankers that is eroding confidence.

The only time when banks provide more transparency is when they are undergoing a bank run.  This blog has demonstrated this with French banks (BNP Paribas and Societe Generale) and US investment banks (Jefferies).

The ECB loaned banks a record 489 billion euros ($636 billion) for three years on Dec. 21 to avert a credit crunch from the sovereign debt crisis. The central bank said earlier this week that the turmoil has taken on systemic proportions not seen since the 2008 collapse of Lehman Brothers Holdings Inc. 

King said the outlook for financial stability has “worsened” since the last ESRB meeting in September, and while intervention by the ECB is expected to “assuage funding problems in the near term, in the longer term private funding markets must be revitalized.”

The only way to bring back the private funding market is for all sectors of the financial system that are currently opaque to have the sunlight of ultra transparency shown on them.

Banks are at the top of the list because they are opaque or in the words of the Bank of England's Andy Haldane 'black boxes'.  To revitalize the private funding market for banks requires the banks disclose their current asset, liability and off-balance sheet exposure details.  It is this data that all the private funding market participants need to assess the risk of each bank and adjust both the amount and price of their exposure to each bank.

Without ultra transparency, all the useful, relevant information that market participants need in an appropriate, timely manner is not available.  It is no surprise that the private funding markets are not functioning as transparency is required for the invisibile hand to operate.

Bank shares have suffered this year as borrowing costs surged in the euro region.... 

King also appealed to banks not to “reduce lending to the real economy” as they increase their capital levels to meet new standards set by regulators. 

The best way to have avoided this regulator induced credit crunch is not to have set the meaningless 9% Tier I capital ratio targets in the first place.

Until banks provide ultra transparency, nobody believes that any reported Tier I capital ratio is anything other than an easily and highly manipulated, meaningless number.  

“We are very conscious there is extreme risk aversion in private financial markets,” he said. 

“We want a more robust banking system so that whatever risks crystallize, whatever their source, the banking system is in a better position than 2008.”...

The only way to have a more robust banking system is to require the banks to provide ultra transparency.  Until this is done, there is no way for the private market participants to know if the banking system really is in a better position than 2008.