The way banks act as a circuit breaker between the excesses of the financial system and the real economy is by absorbing the losses on the financial excesses today and rebuilding their capital base by retaining future profits.
First, the Minister of Economy, Luis De Guindo, for the new Spanish government announced that Spanish banks would have to set aside an additional 50 billion euros for bad real estate debt.
Market participants know that setting aside this much money for bad real estate debt is going to cause many of the Spanish banks to have a negative book capital balance. When asked where the money was going to come from to restore the banks' book capital value to levels consistent with a 9% Tier I capital ratio, he responded
In most cases, banks can make provisions for themselves from their profits. It is something that can be done not in one year, but over several years.This policy and his statement clearly show a recognition that banks have a role to play in absorbing the excesses of the financial system, in Spain's case the losses on the bad real estate debt, and protecting the real economy.
In his testimony before Parliament's Treasury Select Committee, the Bank of England's Director of Financial Stability Andy Haldane expressed the idea that bank's are a safety valve. Talking about bank capital he said
We have gone 30 years without properly emphasising that these rainy day resources are there to be used in a rainy day, and at the moment it's pouring.
I would be perfectly happy to see banks' capital ratios falling… in the current weather.His statement also recognizes that falling capital ratios are necessary if banks are to act as a safety valve and that capital can be rebuilt out of future profits.
It is nice to have European officials confirming a central element of your humble blogger's blueprint for saving the financial system.