ECB's unlimited loans are no panacea for banks

A Bloomberg article discusses how the ECB's Long Term Refinancing Operation (LTRO) temporarily ends concerns over Eurozone banks failing for lack of liquidity, but it does nothing to address the underlying problem of the bad debt on and off their balance sheets.

Regular readers know that your humble blogger sees the LTRO as a useful program to have in place to support my version of the Swedish model for handling a bank solvency based financial crisis (aka, Wall Street rescues Main Street blueprint).

Under the Wall Street rescues Main Street blueprint, the Eurozone banks would be required to recognize the losses on the bad debt on and off their balance sheets.  They would also be required to provide ultra transparence and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details so that market participants could verify the losses were recognized.

Over the weekend, the G-20 asked the EU to enhance its firewall against financial contagion.  As this blog has repeatedly said, the best way to enhance the firewall is to realize that bank book capital is there to absorb losses and not something to be protected as banks have the capacity to generate book capital in the future through retention of earnings and stock issuance.

This is a very important point and needs to be repeated.  Under the Wall Street rescues Main Street blueprint, existing bank capital and future earnings and stock issuance are the primary contributors to the firewall between the excesses in the financial system and the real economy.

It is only under the failed Japanese model for handling a bank solvency based financial crisis that governments are called on to use their creditworthiness to bailout the banks or erect a firewall against financial contagion.

European Central Bank President Mario Draghi’s success in quelling a bond-market rout across the euro region’s periphery masks a failure by the region’s banks to bolster their capital. 

The ECB will offer a second round of unlimited three-year funds on Feb. 29. Firms will seek 470 billion euros ($629 billion), approaching the 489 billion euro take-up by 500 banks at the first long-term refinancing operation on Dec. 21, the median estimate of 28 analysts surveyed by Bloomberg show. 

“The worry is it may act to keep afloat institutions that aren’t exactly viable,” said Stewart Robertson, chief European economist at Aviva Investors in London, which manages more than $425 billion. “This buys time for banks, but does it really provide them with an incentive to sort out their books? The worry is it doesn’t.” 

This is the reason that a Swedish model like the Wall Street rescues Main Street blueprint must be explicitly adopted.

The Frankfurt-based central bank is flooding the market with cheap money to head off a credit crunch, boost lending to companies and consumers, and spur demand for unsecured bank debt.... 

“Providing money so cheaply, for so long, against what is now effectively any collateral whatever, leaves the ECB in a position no central bank would choose to be in,” UBS AG analysts led by London-based Alastair Ryan said in a Feb. 22 note to clients. “It cannot control the credit risk coming onto its books, or at least onto the books of its national central banks. Worse, the success of its interventions risks encouraging politicians to avoid making necessary but difficult decisions.”...

Specifically that the banks their country hosts be required to recognize their losses and disclose their current exposure details.

“This will ease credit flows but won’t stop the great deleveraging,” Huw van Steenis, an analyst at Morgan Stanley in London, wrote in a note to clients. “LTRO is important but not a panacea. While the LTRO should materially ease the euro zone deleveraging process, credit conditions appear likely to remain fairly tight in Spain, Italy and central and eastern Europe.”...

After all, banks are still deleveraging in order to achieve the 9% Tier I capital ratio that bank regulators are requiring.

Of course, if the Swedish model is adopted, regulators would have to abandon the capital ratio target in the near term so there are no impediments to losses being realized -- over the long term, regulators could require banks to achieve the capital ratio target.

A benefit of abandoning the 9% Tier I capital ratio in the near term is it would end the credit crunch regulators precipitated as a result of adopting this target in the first place.