Friday, December 23, 2011

Is the global banking system being killed in the effort to save it?

Are global financial regulators, policymakers and central bankers killing the global banking system in their effort to save it?

Regular readers know that your humble blogger thinks the answer is yes.  I think so because they continue to treat the symptoms of a solvency crisis without addressing the cause.

For example, recently central banks have undertaken a massive two prong approach to provide funding to the Eurozone banks.  This funding is necessary to replace the withdrawal of funds by the private market and the unwillingness of banks that have funds to lend them to other banks.

Why has the private market stopped funding banks and why are banks unwilling to lend to other banks?

Because they have no way of independently determining if they will be able to get their money back!

What type of banking system do you have if only central bankers are willing to fund it?  One that is clearly not functioning properly.

Sir Mervyn King refers to the relationship between the banks and central bank funding as a 'dangerous dependence'.

It is particularly dangerous because as Gillian Tett pointed out in her Financial Times column,

Welcome to a key theme of 2012. During the past four decades, it was widely assumed in the western world that the main role of banks and asset managers was to provide funding to the private sector, rather than act as a piggy bank for the state. But now, that assumption – like so many of the other ideas that dominated before 2007 – is quietly crumbling.

Driving her observation is the pressure being applied on Eurozone banks to pursue the so-called Sarkozy Trade.  Under this trade, banks buy sovereign bonds of their host nation and fund these bonds through long term funding arrangements with the ECB.

How exactly is this different, aside from justifying very large bonuses for the bankers based on the bank's earnings, than the central bank simply handing money to the state?

I prefer not to examine this particularly dangerous Pandora's Box.  I find it unsettling enough to hear policymakers say that banks should be engaging in this trade as a risk-free way to recapitalize.

The fact is the global banking system is insolvent and has been since August 9, 2007.  In addition, no one knows how much equity is needed to recapitalize the global banking system.

Rather than acknowledge this fact, what policymakers, financial regulators and central bankers have engaged in since then is a) an attempt to cover up the insolvency and  b) a stealth attempt to recapitalize the global banking system through a series of programs that has succeeded mainly at generating sizable bonuses for bankers.

Let's look at one of the backdoor ways that has been attempted to recapitalize the banks:  Zero Interest Rate Policies.  In the very short run, say less than a year, banks gush earnings under ZIRP if their liabilities reprice faster than their assets.  Over the medium to long run, say more than a year, the interest being paid on the assets catches up with the zero interest being paid on the liabilities and, with the the collapse of the net interest margin, bank earnings head to zero.

No earnings, no ability to generate capital either through retained earnings or sale of stock to investors.  No additional capital, no ability to recognize the losses hidden on the balance sheet.  No ability to recognize hidden losses, no ability to end the massive distortion to the real economy not recognizing these losses causes....

I am sorry, but the cover-up of the bank solvency problem has been orders of magnitude worse than the solvency problem itself!

I could speculate all day as to why policymakers, regulators and central bankers have chosen to try to cover up the solvency problem.  However, frankly, I do not care why they made this choice.

What I care about is that they stop making this choice before they inflict more damage on the real global economy.

This blog has extensively documented that banks can continue to operate while they are insolvent and support the real economy.  It is time that the policymakers, regulators and central bankers recognize and act on this fact!

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