It is the placement of the financial firewall that is important

Since the beginning of the financial crisis, global policymakers and regulators have placed a financial firewall around bank book capital.

Examples of this firewall include, but certainly are not limited to

• Suspension of mark-to-market accounting and the introduction of mark-to-make-believe for opaque, toxic structured finance securities.

• Purchases of bank equity securities by the government that hosts the bank.

• Regulatory forbearance on recognition of problem loans.

• Stress tests where the regulators make explicit representations about the each large bank's book capital.

By erecting a firewall around bank book capital, global policymakers and regulators have linked their sovereign debt to the book capital values of their banking system.  

Clearly, positioning the financial firewall around bank book capital is something that favors the bankers.  It allows them to continue to privatize any gains and socialize any losses.

But is erecting the financial firewall around bank book capital the appropriate place to erect the firewall?

Regular readers know that your humble blogger's answer to this question is an emphatic no.

By erecting the financial firewall around bank book capital, global policymakers and regulators interfere with the ability of banks to perform one of their core functions:  acting as the safety valve between the excesses of the financial system and the real economy.  In order for banks to prevent the excesses of the financial system from spilling over into the real economy, they have to be allowed to recognize all of their losses from the financial excesses.  

By erecting the financial firewall around bank capital, global policymakers and regulators are preventing banks from recognizing these losses any faster than they have offsetting earnings.  A policy that has resulted in two plus decades of limited economic growth in Japan.

I have recommended that the financial firewall be moved.  Instead of protecting bank book capital it should be moved to protect the real economy.

To protect the real economy, the right place to erect the financial firewall is around the depositors.

As JP Morgan's CEO Jamie Dimon confirmed, so long as deposits are guaranteed and the central bank is willing to lend against a bank's assets, the banks can continue operating indefinitely.  With the financial system protected from collapse, banks can now recognize all of the losses hidden on and off their balance sheets.

Erecting the financial firewall around the depositors breaks the linkage between sovereign debt and bank solvency.  The sovereign no longer has to put money into the banking system to maintain positive book equity.

I suspect that the new Spanish government understand this as it is telling its banks to substantially boost their reserves for bad real estate debt and telling the markets that these reserves will be paid for from the future profitability of the banks.

Regular readers also know that I think that banks should be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  This is the one aspect of my blueprint for saving the financial system that the new Spanish government has not yet adopted.

The are many reasons for requiring ultra transparency including

• Market discipline on the banks stops them from taking unnecessary risks and gambling on redemption while they are retaining earnings to pay for their current losses.

• It restores confidence in the banking system because market participants can assess the risk of the individual banks and see that they are not hiding any losses.

• It frees up the sovereign to issue debt to support economic growth rather than to absorb the losses in bank book capital.