Wednesday, December 21, 2011

Ending the bank/sovereign death spiral dance

Since the beginning of the credit crisis, your humble blogger has been saying that there is no reason that banks and sovereigns need to be engaged in a death spiral dance.

What is the death spiral dance?

It is sovereigns putting their own financial viability at risk by continuing to bailout the banks and effectively socializing their losses.

Who is in favor of the death spiral dance?

Bankers (Wall Street and the City) and their financial regulators favor bailouts.

For bankers, bailouts represent an opportunity to pocket substantial additional compensation while avoiding any potential legal fallout from their pre-crisis activities.

For financial regulators, bailouts represent an opportunity to preserve their information monopoly on all the useful, relevant information on each bank and market participants dependence on the regulators for assessing this information and communicating the results of the assessment.  They too avoid any potential consequences from their pre-crisis activities.

Why is engagement in the death spiral dance optional?

Because there is an alternative.  The alternative is not to protect the banks and in particular their book equity (bailouts are all about increasing book equity).  Instead, banks could be required to provide ultra transparency and governments could guarantee the depositors and on-balance sheet unsecured creditors.

Under ultra transparency, banks would be required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  Market participants would use this information to assess and monitor the risk of each bank and to adjust the amount and price of their exposures based on their independent assessment.

With ultra transparency, all the on and off balance sheet losses currently being hidden by the bank (think extend and pretend) are visible.  As a result, banks will recognize these losses and the mis-pricing of assets in the real economy will end and the economy can recover.

Even though the banks will have negative book equity, they can still operate.  From the perspective of depositors and unsecured creditors, they know they will still get their money back under a government guarantee backed by the host government (in Europe, the government guarantee would also be backed by the European Financial Stability Fund and European Stability Mechanism).

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