Friday, January 20, 2012

BoE's Andrew Haldane confirms that banks can operate just fine while insolvent

In his speech at the Information for Better Markets conference, Andrew Haldane, Executive Director Financial Stability and Financial Policy Committee member, confirmed that banks can operate just fine while they are insolvent.

In examining accounting on an amortized cost basis versus mark-to-market basis, he noted that because the maturity of bank assets tends to be longer than the maturity of its liabilities, the driver for how the assets should be valued is the maturity of the liabilities.

As he said

The bank’s entire asset portfolio ought really to be valued at market (and potentially fire-sale) prices. 
For a bank with long-maturity illiquid assets, these differences in valuation convention could have a material impact on solvency. They may even be the difference between solvency and insolvency. 
Had their loan books been marked to market during the crisis, UK banks would have had significantly negative net worth for a protracted period (Chart 2). Most global banks would have been in a similar position.  
Please read the highlighted section again as it was well known to the market that the banks were insolvent - the market value of their assets exceeded the book value of their liabilities.

In case there is any doubt that this fact was well known, every bank knew that it was insolvent and given that its competitors held similar assets, it was not a great leap to assume they were insolvent too.

With Chart 2, Mr. Haldane establishes that banks can have negative net worth for a protracted period of time.  He also confirms a critical element of the blueprint for saving the financial system.

The critical element is that banks can recognize all the losses from the financial excesses in the system today.  The result of recognizing these losses will be a negative net worth for accounting purposes (the market already knows the banks have a negative net worth for economic purposes).

By not commenting on its absence, Mr. Haldane confirms that banks can continue to provide payment services and loans while having a negative net worth.

With Mr. Haldane's observation, I have now been able to confirm everyone of the assumptions underlying the blueprint to save the financial system.

The question now is when will the blueprint for saving the financial system be adopted so that we can stop damaging the real economy.

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