How are we ever going to re-establish trust in the banking system?

At the beginning of the financial crisis in a speech at the London School of Economics, the Queen of England asked how if everything was going so well, the economics profession managed to miss the signs that we were headed for a global financial crisis.

If she were to be invited back, I suspect that she might be tempted to ask, given everything that the governments have done since the beginning of the credit crisis, how are we ever going to re-establish trust in the banking system?

Regular readers know that my solution is to require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this disclosure, market participants can independently assess the risk of each bank and trusting in their assessment adjust the amount and price of their exposure to each bank.

Given the number of economists that I have talked to who have rejected ultra transparency, which happens to be a necessary condition if the invisible hand is to operate properly and buyers are going to know what they are buying when it comes to investing in banks, I am interested in what they propose that should restore trust.

To date, economists have recommended and governments have implemented a number of methods to restore trust that have failed including

• Stress Tests.  Financial regulators are engaging in an annual ritual of subjecting financial institutions to stress tests.  As this blog has documented, these tests are absolutely worthless for restoring trust and confidence in the banking system.  For example, in Europe, within weeks of the announcement of the results for the last two stress tests, a bank that passed the stress test has imploded.  

• Higher Capital Ratios.  In what is admittedly an over-simplification, higher capital ratios are suppose to signal to the market that banks are safe and can be trusted because they have more loss absorbing capacity.  If this were remotely true, then the EU interbank lending and unsecured debt markets should not have frozen while banks are increasing their capital to meet the 9% Tier I capital requirement.