Thursday, December 8, 2011

Donald Kohn explains why regulators have not addressed the global solvency crisis

In a speech, the Bank of England's Financial Policy Committee member Donald Kohn explained why regulators have not addressed the global solvency crisis.  He discussed the difficulty with implementing countercyclical macroprudential policy when times are tough.

When the economy is weakening and bad debts are building, easing [capital and liquidity] requirements may reduce the effect of financial sector problems on the real economy.   
There is no 'may' in the effect of these policy actions on the real economy.  It has been well known since the Great Depression that making banks absorb the losses on the excesses in the financial system does reduce the effect of financial sector problems on the real economy.

This blog has referred to this as banks acting as a safety valve between the excesses in the financial system and the real economy.

You don't have to take your humble blogger's word that this works.  The NY Fed has documented that it works.

Contemporary observers consider the [US] Bank Holiday and [FDR's] Fireside Chat a one-two punch that broke the back of the Great Depression....
Roosevelt’s oratory certainly played an important role, but only the financially naive would have believed that the government could examine thousands of banks in one week to identify those that should survive. 
According to Wigmore (1987, p. 752), “The federal review procedure for reopening banks also had too many weaknesses to create much confidence, given the number of banks reopened, the speed with which they opened, and the lack of current information on them. There were no standards for judging which banks should reopen.”...
This article demonstrates that the Bank Holiday that began on March 6, 1933, marked the end of an old regime, and the Fireside Chat a week later inaugurated a new one. 
The Emergency Banking Act of 1933, passed by Congress on March 9—combined with the Federal Reserve’s commitment to supply unlimited amounts of currency to reopened banks—
created de facto 100 percent deposit insurance. 
Moreover, the evidence shows that people recognized this guarantee and, as a result, believed the President on March 12, 1933, when he said that the reopened banks would be safer than the proverbial “money under the mattress.” 
Confirmation of the turnaround in expectations came in two parts: the Dow Jones Industrial
Average rose by a statistically significant 15.34 percent on March 15, 1933 (taking into account the two-week trading halt during the Bank Holiday), and by the end of the month, the
public had returned to the banks two-thirds of the currency hoarded since the onset of the panic.
Breaking the back of the Great Depression sure sounds like making banks absorb the losses on financial excesses unambiguously works.

I can hear the objections already.  The article refers to an implied 100% deposit guarantee.  It does not mention banks taking the losses.

Literally true, but once there is an implied 100% deposit guarantee in place, then there is no reason that a bank cannot recognize all of its losses.  It does not have to fear a run as no-one is looking at its financial statements.

As a practical matter, once the government formally began guaranteeing deposits later that year, regulators had an incentive to make sure the banks cleaned up their bad assets.

Returning to Mr. Kohn's speech...

But how do you know the problems won’t get much worse, perhaps for reasons entirely external to the economy in question and out of control of the authorities.   
If conditions do continue to deteriorate substantially, releasing capital and liquidity buffers – lowering requirements – could come back to haunt the economy and the authorities if it results in widespread failures, unemployment as credit tightens, and if it comes to require fiscal action to stem the downward slide.  
Now there is a prescription for regulators never addressing a solvency crisis.  After all, it is always possible that the situation will get worse.

Even if the situation gets worse, it does not matter so long as three conditions hold true.

First, the central bank continues to be willing to lend against good collateral.  Second, the government continues to guarantee the deposits.  These two conditions assure that an insolvent bank can continue operating indefinitely.

Third, the banks provide ultra transparency by disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.  This condition means that market discipline will prevent banks from taking unnecessary risks and gambling on redemption.

Regular readers will recall that your humble blogger predicted at the start of the solvency crisis that the global economy was in a downward spiral that could only be stopped if the solvency issue was addressed by requiring ultra transparency for all the opaque areas of the global financial system.

So where are we today more than four years after the start of the solvency crisis on August 9, 2007?

The Telegraph's Ambrose Evans-Pritchard observed that today all the Eurozone and UK banks are insolvent and policy makers and regulators need to face up to it.

He could also have observed that the global banking regulator review process, including stress tests, has too many weaknesses to create confidence.  The key weakness being the lack of current information available to market participants so that they can independently assess the solvency of each bank.

He could also have observed that the trigger for the Eurozone banks causing a credit crunch was the regulators insistence that banks meet a 9% Tier I capital ratio.

The FPC has faced just such an issue as the situation in the euro area worsened last summer and fall, and its discussion of the conflicting pressures is reflected in the record of our September meeting, already published.   
The committee concluded that lowering buffers would not be appropriate at that time, out of concern about what might be coming next.    
Buffers that the Great Depression showed are meaningless when the government is implicitly guaranteeing 100% of the deposits.

Wait a second, given the stress tests, aren't the governments morally obligated to bailout investors?  Isn't this a 100% deposit guarantee?
The cost of leaning unnecessarily hard against expanding credit and rising asset prices would be growth and innovation foregone – very hard to see. The cost of inadequate capital and liquidity is large and visible – a loss of confidence and an unstable financial system.  

A direct link between high levels of bank book capital/liquidity and confidence and a stable financial system may in theory exist.  Then again, it might not. [Pre-deposit insurance we had high levels of bank book capital and liquidity, but there were frequent periods of instability characterized by bank runs.  Post-deposit insurance, we had low levels of bank book capital/liquidity and long periods of financial stability.]

A direct link between disclosure to market participants of all the useful, relevant information in an appropriate, timely manner and confidence and a stable financial system has been definitively shown to exist.  

There is no clearer example of this linkage than the government's implied guarantee of 100% of deposits in the Great Depression.  With knowledge of the implied deposit guarantee, bank runs ended and deposits flowed back into the banking system.

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