BIS's Borio supports Swedish model: balance sheet repair basis for recovery

In a Wall Street Journal article, the BIS's Claudio Borio effectively endorsed adopting the Swedish model for handling a bank solvency led financial crisis.

In doing so, he confirmed much of what your humble blogger has written about in this area over the last several months.

Under the Swedish model, banks are required to recognize the losses on the excesses in the financial system today and to rebuild their book capital through future retained earnings.

The excesses in the financial system are the debts in excess of the borrowers capacity to pay.

The alternative to the Swedish model is the Japanese model for handling a bank solvency led financial crisis.  Under this model, the focus is on preserving bank book capital levels.  As a result, the losses on the financial excesses are hidden and only realized as banks generate earnings in excess of banker bonuses, dividend payments and de minimus book capital increases.

Mr. Bario condemns several of the policies that are necessary to support the Japanese model including low interest rates,  quantitative easing, bailouts and regulatory forbearance.

Economic and financial downturns triggered by tainted balance sheets, such as the one experienced around the world in 2008, need to be confronted by repairing those balance sheets since policy impact becomes limited in such times, the deputy chief economist of the Bank for International Settlements said Wednesday. 

"Balance sheet repair lays the groundwork for a self-sustaining recovery," Claudio Borio said at a world economic and financial stability conference in New York. "Traditional monetary and fiscal policies need reconsideration. The key point is that room for policy maneuvering is greatly constrained."

The only way to repair the balance sheet is to recognize all the losses hidden on and off the balance sheet.

The only way to convince market participants that these losses have been recognized is if the banks are required to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.

Borio cites a bad example of such efforts in Japan, where policymakers have struggled to revive strong growth in the past decade. 

Struggled is too kind as Japan's GNP shrank from 1995 to 2010.

When monetary authorities respond with aggressive and protracted periods of easy policy, Borio says it presents several pitfalls. 

"It buys time, but can also delay the end-game of balance sheet adjustment," Borio said. "It can mask underlying balance sheet weakness and can encourage risk-taking behavior." 

Major central banks around the world, including the U.S. Federal Reserve, have been conducting an unprecedented series of easing programs since 2008 in efforts to bolster their recession-stricken economies. The Fed's own balance sheet has ballooned to unprecedented levels as it became the biggest buyer of U.S. debt amid its bond-buying initiatives, greatly manipulating yields offered by Treasury bonds. 

"This atrophies financial markets as central banks take over, and this masks and delays financial signals," Borio said....

Response from the fiscal end also poses risks by further weakening countries' financial positions, Borio said, especially with governments in Europe and the U.S. already struggling with massive debt loads. 

Measures that focus exclusively on recapitalizing banks can also generate wrong incentives. Credit, in this case, flows into the wrong hands by keeping bad borrowers afloat and charging higher rates to healthy borrowers, Borio said.

Bottom-line:  the Japanese model is good for the banks and bad for the real economy.  As a result, the Swedish model should be adopted instead.