The intent of this post is to use his column to provide readers with an overview of how these issues are interconnected.
Regrettably, [the Bank of England's Mervyn King is] only telling it as it is. We stand on the brink, apparently incapable of pulling back.
Events on the Continent have come to feel much like the drift into war. There is a feeling of powerless inevitability about it ....
Europe is already back in the midst of a credit crunch, with its banks largely frozen out of wholesale funding; eurozone banks have become so risk averse that they prefer to lodge their excess liquidity with the European Central Bank than lend to each other. Across the Continent, banks are shrinking their credit.The wholesale funding freeze results from the fact that no bank can determine if the borrower is solvent or not. This point was driven home when Dexia passed the European bank stress tests and then had to be nationalized a couple of months later.
The credit crunch was triggered by the financial regulators insisting that the banks meet a 9% Tier I capital ratio.
How close are UK banks to being similarly engulfed? Sir Mervyn trod a fine line at his press conference on Thursday between warning banks to prepare for the worst on the one hand, and on the other trying to play down fears of a renewed funding crisis.
For now, the UK banking system is mercifully not quite as stressed as its European counterparts. Thanks to earlier Government bailouts and other sources of new equity, UK banks remain relatively well capitalised. They have also already financed themselves with term lending through to the end of this year, so they don't face the same immediate threat from the funding drought.
Yet they surely cannot remain immune for much longer. Thursday's Financial Stability Report from the Bank of England warns that issuance of term funding has been very weak since May.
Worryingly, UK banks have £140bn of it due to mature in 2012, with most of that concentrated in the first half of the year. If the Bank of England fails to provide alternative liquidity, UK banks will soon be struggling.A condition that could be easily avoided if the banks provided ultra transparency. By disclosing on an on-going basis their current assets, liability and off-balance sheet exposure details, UK banks would be providing market participants with the data they need to independently assess the solvency of the UK banks.
When market participants are comfortable with a bank's solvency, it is easier to raise funds.
In addition, the UK banks would be expanding the pool of collateral they have to pledge. With market participants valuing their loan portfolios, UK banks could, in theory, pledge whole loan portfolios as collateral to the Bank of England. The use of whole loan portfolios would take the pressure off of using government securities as central bank collateral. This would ease funding in the repo markets.
According to Sir Mervyn, the antidote is more capital. The greater the bank's capital reserves, the more confident markets can be that their money is safe and the easier it therefore is for banks to fund themselves.
Regrettably, it is quite difficult to see where this capital is gong to come from.
Private investors? Forget it. As things stand, virtually all European banks are regarded as essentially "uninvestible".This would change if there was ultra transparency as investors would be able to independently assess the risk of an investment in the bank.
Governments then? Again, forget it. They are all out of money.Governments should never have invested in banks in the first place.
Banker bonuses? That's the source that Sir Mervyn seems to have set his heart on. Yet despite the obvious political appeal, it is also unrealistic. The bonus pool is too small to make much of an immediate impact on capital....So long as a bank has less than the Admati-Miles Capital Ratio (the value of book equity to risk weighted assets equals 20%), bonuses should be paid in stock. A little capital issuance being better than none.
In any event, the Governor's call for increased capital buffers is somewhat at odds with the Government's parallel aim of increased lending.
Where the capital buffer cannot be improved by raising more capital, it tends to get done instead by shrinking the lending book....As previously stated, calling for increased capital buffers triggered the credit crunch in the Eurozone.
One of the benefits of ultra transparency is that it can also be applied to structured finance securities. In the same way that ultra transparency allows banks to be valued, it also allows structured finance securities to be valued by secondary market participants.
With demand for securities in the secondary market, the structured finance market will reopen and banks can both continue to originate loans which they subsequently distribute and increase their capital buffers.
It's obviously right that financial regulators urge banks to prepare for the worst; it would indeed be somewhat surprising if they needed to be prompted....Ultra transparency allows all market participants, including the banks, to prepare for the worst.
With ultra transparency, each market participant is responsible for all gains and losses on its investment exposures. As a result, market participants will adjust the amount and pricing of their exposures to reflect the risk of the investment. Particularly the risk that they might lose 100% of their investment.
When someone borrows far more than they can ever repay, ultimately the creditor always takes a haircut. Essentially, that's what the eurozone crisis is about. The debtors are already insolvent, and the creditors find their own solvency threatened by the insolvency of their debtors.With ultra transparency, market discipline forces the creditors to take a haircut. After all, market participants know what exposures the creditors have and the market participants are capable of valuing these exposures.
Ultra transparency forces banks to act as a safety valve between the excesses of the financial market place and the real economy. It is the bank capital account that absorbs the losses on the excesses rather than the real economy.
Market participants know that a bank with negative book equity can operate indefinitely so long as depositors think the deposit guarantee is good and that central banks will lend against good collateral.
Should a bank have negative book equity, ultra transparency is needed so that market discipline can prevent the bank from trying to gamble on redemption as it rebuilds its book equity.