Jeremy Warner highlights need for a solution to solvency crisis

In his Telegraph column, Jeremy Warner discussed how by itself the ECB's Long Term Refinancing Operation is not going to solve the Eurozone's problems.  Rather it is going to buying time in which the problems can be solved.  He then observes that what is now needed is a solution to the crisis.

Regular readers know that this blog is unique in its focus on presenting the solution to the bank solvency led financial crisis as well as documenting its proven effectiveness.

The solution is to implement a variation of the Swedish model for handling a bank solvency led financial crisis.  Under this variation, Wall Street and the banks rescue Main Street.

When something looks dangerous, it generally is. And few things look quite so high-wire right now as the European Central Bank’s efforts to hold the euro together by flooding the banking system with free money....

When Mario Draghi, the new ECB president, embarked on the programme shortly before Christmas, it was hailed as a masterstroke which had saved the eurozone from financial and economic calamity. Even the Jeremiahs of Germany’s Bundesbank, proud keepers of the sacred flame of monetary conservatism, were stunned into grudging acquiescence by the evident seriousness of the crisis. But now the doubts are beginning to set in, and with good reason. 

The measures adopted are so extreme that it is no longer possible to know where they might lead, or what their eventual consequences might be. There is no precedent or road map for this kind of thing. All we do know is that they fail to provide any kind of lasting solution to the single currency’s underlying difficulties, which are still largely unrecognised and unaddressed.  

If Draghi’s intention was to buy time, it’s not being well used. 

It might be argued, of course, that a sticking-plaster solution is better than no solution....

What [Quantitative Easing and the LTRO] try to do is stop the contraction of the money supply threatened by very rapid deleveraging in the banking sector. As banks shrink their balance sheets, by writing off bad debts or refusing credit, the supply of money also shrinks. If unaddressed, this will cause economic collapse, as during the Great Depression....

I am not sure that the supply of money shrinks when banks write off their bad debts.

As I recall and it has been over 30 years since I worked at the Federal Reserve in the area that produced the monetary aggregates, bank equity is not included in the money supply. Bank deposits yes.  Bank equity and other forms of bank capital, no.

Refusing to supply credit contributes directly to economic collapse.  However, the reason that Eurozone banks are refusing to provide credit is the requirement by the financial regulators that they achieve a 9% Tier I capital ratio by the end of June.

Much of the Mediterranean rim is already in a depression, with disastrous levels of unemployment, contracting output, and a collapsing money supply. 

What was going on prior to the first tranche of LTROs was a banking run similar to that which culminated in the collapse of Lehman Brothers, as money was withdrawn from the troubled periphery and redeposited in the more solvent core.

A bank run that this blog has been documenting for the last year.

In addition, the sticking-plaster solution that is the LTRO is also there to deal with the fact that interbank lending and unsecured bank debt markets are frozen.  Without funding from the ECB, many Eurozone banks would not  have the funds they need to redeem the interbank loans and unsecured bank debt as it matures throughout 2012.

The ECB’s actions have succeeded in easing these difficulties, and removing the immediate threat of cascading insolvency throughout the European banking system. 

But they have also stored up big problems for the future. To get the cheap funding, banks must lodge their better-quality collateral with the ECB.

My understanding is that the ECB was willing to take really dodgy collateral under the LTRO.  To a certain extent as banks consolidate their ECB borrowing under the LTRO, this frees up the better-quality collateral that had been previously pledged to the ECB under different programs.

The effect is to dilute the quality of their remaining balance sheet, making it even more difficult to get funding from the markets as normal.

As previously noted, even with better-quality collateral, the interbank lending and unsecured bank debt markets are frozen.  This is a result of the simple fact that no market participant has access to the data they need so that they can assess the risk of any bank (there is a reason the Bank of England's Andrew Haldane refers to banks as 'black boxes').

What market participants learned at the beginning of the credit crisis when they lost trillions on opaque, toxic structured finance securities is not to invest in black boxes.

As a result, European banking is becoming ever more dependent on ECB life-support, with no obvious way off it....

This is where my version of the Swedish model under which Wall Street and the banks rescue Main Street comes in.  Under the blueprint, Wall Street and the bank recognize the losses today on all the excesses in the financial system.  Then, they rebuild their book capital through retention of future earnings and proceeds from newly issued stock.

To insure that they recognize the losses on and off their balance sheets and do not gamble on redemption, financial institutions will have to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

The ECB’s activities also create huge potential liabilities for the more solvent countries that ultimately – through their national central banks – provide the funding for all this. What is in essence happening is that the banking risks of the European periphery are being progressively foisted onto the taxpayers of the more solvent core. Once people in those countries actually realise what’s going on, they’re going to hit the roof.

By requiring the banks in the periphery to recognize their losses and provide ultra transparency, the taxpayers of the more solvent core are able to limit their exposure and put in place a mechanism for winding down their exposure (the mechanism the rebuilding of the bank balance sheets).

Taken as a whole, the sophistry of the process is breathtaking. The ECB is in effect being used as a mechanism for making fiscal transfers between countries, which can only legitimately be agreed by elected governments. 

To save the politicians’ blushes, the transfers are being executed via an unelected monetary authority. 

It’s another example of how legal and democratic niceties seem to have been abandoned in the scramble to save the euro. 

The fiscal compact, almost certainly illegal within the wider framework of the European Union, is not the paving stone to fiscal federalism it pretends to be, but a form of economic dictatorship which seems to condemn much of the periphery to permanent depression. 

The more policy-makers dig, the deeper into the mire they sink....

Europe has no strategy for growth, no strategy for jobs, and in truth, no strategy for saving the euro. The project is broken beyond repair.

Your humble blogger's solution offers many additional benefits.

First, it does not require legal and democratic niceties to be set aside to preserve bank book capital.

Second, it does not require an unelected monetary authority to make fiscal transfers that only elected governments should make as it requires no fiscal transfers.

Third, it ends the policy-makers sinking into the mire and allows them to focus their resources on how to grow the Eurozone.