Monday, January 2, 2012

Saving the Eurozone means no more socializing the losses and privatizing the gains

Ultimately, saving the Eurozone will require ending the policy of socializing the losses and privatizing the gains.  This policy has to end because the market does not believe that together the Eurozone countries have the ability to absorb the losses that are currently hidden in the financial system.

An example of the market expressing its loss of confidence is the freezing of the interbank lending market in the Eurozone.

Why would Eurozone banks stop lending to each other?

Because each Eurozone banks knows what losses it is hiding and they are worried about getting repaid because they cannot determine the size of the losses that banks they might lend to are hiding.  Furthermore, the banks are nervous about the capacity of the host country to bail out its banks.

This is a problem that existed when the financial crisis began on August 9, 2007.  This symptoms associated with this problem were temporarily relieved by adoption of socializing the losses.  Unfortunately, it is now clear that the losses are bigger than the Eurozone can support.

Since the beginning of the financial crisis, your humble blogger has said there is an alternative to socializing the losses.  That alternative is to have banks perform their safety valve function and act as a circuit breaker between the excesses of the financial markets and the real economy.

I understand why regulators are reluctant to adopt this policy:  financial institutions are going to show massive negative book capital when they are required to recognize their losses and the regulators are afraid this will trigger a run on the financial system.

This assumption is fundamentally wrong.

First, there is deposit insurance.  What holds the deposits in place is the perceived solvency of the government and not whether a bank has a positive or negative book capital account.

Second, the market knows that there are significant losses hidden in the banking system.  It has already adjusted to this fact (for proof, just look at how in the late 1980s bank stock prices rose dramatically after banks came clean about their losses on loans to less developed countries).

One of the reasons that financial institutions should be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details is it ends hiding losses.

All market participants, including other banks, can see what the true condition of each bank is.  It is only when market participants can independently assess the true condition of each bank that trust in the financial system is restored.

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