Thursday, March 1, 2012

Banks should learn to go it alone

In his Financial Times column, former ECB executive board member Lorenzo Bini Smaghi identifies the fundamental problem with the Japanese model for handling a bank solvency led financial crisis:  eventually banks have to go it alone.

Since the beginning of the financial crisis, banks have been protected at significant cost to society.

The latest example is the ECB's Long Term Refinancing Operation.  It was needed as a direct result of the freezing of the interbank lending and unsecured debt markets.  Simply put, banks needed the access to funds or they would be unable to pay their maturing debts.

Interestingly, central bankers are describing the resulting increase in the ECB's balance sheet from LTRO as reflecting "a change in the composition of financial market participants' portfolios towards less-risky assets"and "the prevention of deflation".

This benign description glosses over a very important point.  As the Bank of England's Andrew Haldane observed about current disclosure practices and banks, banks are 'black boxes'.

The interpretation of investor behavior changes when the fact that banks are black boxes is taken into account.  The refusal to invest reflects a buyers' strike and an unwillingness to blindly gamble on the contents of a black box.

The lesson investors learned through trillions of dollars of losses on opaque, toxic structured finance securities is not to gamble on the contents of a black box.

When investor behavior is interpreted in this way, the solution for ending the buyers' strike and letting banks go it alone becomes apparent.  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 information, market participants can assess the risk of each bank and adjust the amount and price of their exposure based on this assessment.

Requiring ultra transparency also ends implementation of the Japanese model and adoption of the Swedish model for handling a bank solvency led financial crisis.  Market discipline will force the banks to recognize their losses.  While this is bad for bank book capital today, it is good for society as banks can rebuild their book capital through retention of future earnings.
With the €530bn lent to banks through its latest three-year longer-term refinancing operation, the size of the European Central Bank’s balance sheet has increased to unprecedented levels, raising three separate concerns. Not all are justified.... 
If the increase in central bank money helps commercial banks to finance additional private or public consumption and investment, over and above the economy’s productive potential, it may indeed fuel inflation. 
If, instead, the demand for central bank money reflects a change in the composition of financial market participants’ portfolios, towards less-risky assets, the increase in central bank money is not inflationary. It contributes instead to preventing deflation. 
The data show that market participants’ current demand for central bank money does not reflect an intention to increase their balance sheets but rather their difficulty in accessing financial markets – the result of a generalised increase in risk aversion. Replacing market financing with central bank funding has prevented a sharp contraction in banks’ liabilities, which would have induced a drastic deleveraging and possibly a credit crunch....
Of course, all of this could have been avoided if banks were not black boxes and instead offered ultra transparency.
The large amount of liquidity will, of course, have to be mopped up once financial markets have recovered, to avoid fuelling inflationary pressures. 
The process will be partly endogenous, as commercial banks in the eurozone will request less central bank money as risk aversion subsides, or will reimburse existing loans in advance, as the three-year LTROs allow. The ECB can hasten this process, if needed, by raising the refinancing rate, by increasing the spread between the refinancing and the deposit rate, by adopting variable rather than fixed-rate tenders for its operations, or by issuing term deposits or certificates of deposit.
In the absence of ultra transparency, there is no reason for risk aversion to subside.  Buyers are on strike and unwilling to gamble on the contents of a black box.

Despite the central banks' best efforts, buyers still have alternatives to invest in other than banks (or structured finance securities).
The second concern relates to the overall risk a large balance sheet may create for the central bank and its shareholders. This concern is mitigated by the fact that the ECB lends against collateral. For a loss to materialise, the counterparty has to be insolvent and the collateral must be sold at a price lower than the central bank’s valuation (market price minus a haircut). These events are unlikely to occur simultaneously. 
In fact, markets are concerned about the opposite issue – that the ECB has de facto acquired preferred creditor status. The recent Greek bonds swap, which allowed the ECB to avoid loss, has confirmed this status. 
Under these circumstances, the larger the central bank balance sheet, the larger the risk shifted to the remaining unsecured bondholders, who might be more and more discouraged from lending to banks as they would find it harder to return to market financing.
Increasing subordination might contribute to keeping the interbank lending and unsecured debt markets frozen, but it is not what caused them to freeze in the first place.

The cause is no market participant, other than the bank regulators, has access to the information needed to assess the risk of any bank. So long as banks are black boxes, this will be true.  Hence the reason that investors are taking back their principal at maturity and investing elsewhere.

What is required to unfreeze the interbank lending and unsecured debt markets is ultra transparency.
This raises a third, more serious concern: that cheap three-year funding creates a disincentive for eurozone commercial banks to restructure their balance sheets and strengthen their capital base, as they must to stand on their own feet once the crisis is over. Banks may become addicted to easy central bank financing and delay the adjustment indefinitely. 
This can be prevented only if supervisors put sufficient pressure on bank managers and shareholders to continue adjustment, and to use central bank funds only as a temporary, exceptional source of financing. However, supervision in the eurozone is implemented at national level, with little incentive to pursue these objectives rigorously and on a level playing field.
This will only occur if the Eurozone policymakers agree to end the implementation of the failed Japanese model and adopt the Swedish model for handling the current bank solvency led financial crisis.

There is one major barrier to this occurring:  bankers are going to fight this to preserve their bonuses.

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