Financial firewalls: a tool for bankers to secure their next round of bonuses

In a Bloomberg article, Treasury Secretary Geithner urges Europe to be aggressive and creative in dealing with the ongoing financial crisis.

“The success of the next phase of the crisis response will hinge on Europe’s willingness and ability, together with theEuropean Central Bank, to apply its tools and processes creatively, flexibly and aggressively to support countries as they implement reforms and stay ahead of markets,” Geithner said. 

While cautioning Europe to stay vigilant, Geithner was less pessimistic than when he warned the IMF in September to intensify its efforts to avoid the “threat of cascading default, bank runs and catastrophic risk.”

Naturally, at the top of the list of creative tools for staying ahead of the threat of cascading default, bank runs and catastrophic risk are financial firewalls.

There are two sets of firewalls.  First, the Europeans have pledged almost $1 trillion to the combined European Financial Stability Fund (EFSF) and the European Stability Mechanism (ESM) firewall.  Second, the IMF recently received $430 million more to shore up its resources.

As Liam Halligan observed in his Telegraph column

The very size of the “bazooka” is supposed to reassure global markets any contagion will be contained. That’s the theory behind financial firewalls – that they’ll never actually be needed. 

Such reasoning is defendable but only if the breathing space provided is used to press ahead with genuine structural solutions to the issues that necessitated the firewall in the first place.

Mr. Halligan goes on to define the problem for which genuine structural solutions are needed and then discusses what genuine structural solutions must occur so that the firewalls are not actually needed.

Europe’s almost entirely unrestructured banking sector remains bombed-out, sitting on trillions of euros of undeclared losses. Member states continue to bail out their busted banks using “virtually printed money”, the banks in turn using such bail-outs to buy member states’ sovereign debts. 

This is unsustainable — so, by definition, will not be sustained. These IMF and eurozone firewalls may allow the party to continue a while longer. But the ultimate hangover will be even worse. 

What the eurozone desperately needs, as this column has argued ad nauseam, is for its banks to be forced, under threat to executives of custodial sentence, to fess-up to the massive losses on their balance sheets. 

The worst of those losses must be written off, resulting in bank restructurings, with salvageable loans placed in a state-sponsored “bad bank” in the hope some value can be recovered. 

Doing this will cause a lot of pain and yet more debt will hit some nations’ balance sheets. But there really is no alternative. We’re well, well beyond the point where any eurozone solution will be palatable. The harsh medicine of write-downs and debt restructurings should be implemented behind the various firewalls, while they can still be erected. 

None of this will happen, of course. 

Why can't the banks disclose the losses on and off their balance sheets?

Because the EU, like the UK and US, has adopted the Japanese model for handling a bank solvency led financial crisis.  Under this model, the book capital level of banks is protected and, by definition, losses are not disclosed.

In fact, losses are only recognized to the extent that the bank has earnings in excess of the amount needed to pay banker bonuses and dividends.

The existence of financial firewalls provides cover for the bankers to continue taking their bonuses.  The financial firewall is suppose to eliminate the risk of contagion and if all is well at the bank then why shouldn't the bankers get their bonuses.