Sunday, February 5, 2012

How Wall Street rescues Main Street

Ultimately, my blueprint for saving the financial system can be summed up as:  How Wall Street rescues Main Street.

The way Wall Street rescues Main Street is by acting as the safety valve between the excesses in the financial system and the real economy.  Banks are uniquely positioned to recognize the losses on the excesses in the financial system today and rebuild their book capital through future retained earnings.

Please note that this is the opposite of what has been going on since the beginning of the financial crisis in 2007 where the real economy is being asked to absorb the losses from the financial excesses.  One consequence of the real economy absorbing these losses is austerity.

There are signs that policy makers are beginning to realize that Wall Street can rescue Main Street.

For example, Spain recently announced that its banks were required to recognize the losses on their bad real estate debts.  The banks are then suppose to rebuild their book capital through future retained earnings.

The ability of Wall Street to rescue Main Street is based on three features of our financial system.

  • Deposit guarantees.  Since the 1930s, governments have explicitly and implicitly guaranteed 100% of bank deposits.  As a result, depositors do not care about either a) the actual solvency of their banks or b) the book capital of their banks.  Depositors only care if they can get their money back.  This frees up the banks to recognize the losses on financial excesses today.
  • Lender of last resort.  Since the 1870s, central banks have provided liquidity to any bank presenting good collateral.  Recently, the ECB both expanded what it would accept as collateral to include loans and how long it would lend money.  The result is that Eurozone banks can replace any funds they lose from deposit withdrawals or maturity of interbank loans and unsecured debt.  This liquidity allows banks to continue to support the real economy by originating loans and providing payment services.
  • Ultra transparency.  Financial regulators are suppose to require that banks disclose all their useful, relevant information in an appropriate, timely manner.  Currently, this is not done as bank disclosure has them resembling, according to the Bank of England's Andrew Haldane, 'black boxes'.  If financial regulators actually did require an appropriate amount of disclosure, banks would be required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this information, market participants would know if all the losses had been realized and would be able to exert discipline while banks are rebuilding their book capital so that management does not gamble on redemption (this addresses the issue of excessive risk-taking in banking).

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