ECB's Draghi calls for EU bank reform

As reported by the Wall Street Journal, the ECB's Mario Draghi's call for EU bank reform gets closer to but does not fully adopt your humble blogger's blueprint for saving the financial system.

In testimony to European Parliament, Mr. Draghi criticized the efforts by national regulators to get a handle on the state of their countries' banks, an error that he said makes it far more expensive to recapitalize struggling financial institutions. 

When regulators are faced with banks needing more capital, they "underestimate the problem and then come out with a second or third or fourth assessment," he said, citing Franco-Belgian bank Dexia SA and Spain's Bankia. 

"That's the worst possible way of doing things. Everybody ends up doing the right thing but at a high cost and price," he said.... 

Your humble blogger could not agree more that how national regulators are handling their financial institutions is the 'worst possible way of doing things'.

I have written extensively on how the only way to end the 'worst possible way of doing things' is to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

So long as national financial regulators have an information monopoly on all the useful, relevant information on the financial institutions hosted by their country, market participants, including financial regulators in other countries, are dependent on these regulators to both properly assess the information and communicate the results of this assessment.

Clearly, there are a number of institutional hurdles that make it virtually impossible to both assess and communicate the results.

I have talked about several of these hurdles including:  if the assessment is done correctly, the bank's successfully challenges the assessment to more senior regulators (regulators only speak with one voice); if the assessment is right and the senior regulators support it, the senior regulators still have to deal with politicians who they might not be able to convince (after all, when real estate prices are increasing, everything looks okay); if the assessment is right, senior regulators still have to overcome concerns about the safety and soundness of the financial system before they would publicly disclose the assessment to the other market participants.

Mr. Draghi called for a banking union entailing a euro zone-level fund for resolving failed banks, a euro zone-level deposit insurance guarantee system, and banking sector supervision that is more centralized on a European level. 

Under your humble blogger's blueprint, resolving failed banks remains with the host country.  However, the blueprint has a much different definition of failed banks than Mr. Draghi is using.

The blueprint explicitly recognizes that in a modern financial system with deposit guarantees and access to central bank funding, banks can operate and support the real economy for years even when they have negative book capital levels.

What distinguishes a failing bank from a non-failing bank is the non-failing bank has a franchise that allows it to generate and retain earnings to rebuild its book capital levels.

It is only the banks that after recognizing all the losses currently hidden on and off their balance sheet that cannot generate earnings that need to be resolved.

The euro-zone's permanent rescue fund, the European Stability Mechanism, could be used to recapitalize banks, he suggested. Under its charter, the ESM is only allowed to lend to governments. That makes it difficult for many governments to recapitalize banks without putting unbearable stress on their own public finances, an issue that is particularly acute in Spain. 

The blueprint explicitly recognizes that a modern banking system does not require bailouts as the banks can generate earnings in the future to rebuild the book capital decline that results from recognizes all the losses on and off their balance sheets today.

As a result, the ESM is freed up to be used to backstop the government's deposit guarantee.

Mr. Draghi's calls for more European integration are "spot on," said Philip Whyte of the London-based think tank Centre for European Reform. "It's a totally dysfunctional currency union. You need reforms to make a more fiscally-centralized union," he said....

The blueprint explicitly recognizes that information is the key to the new model for bank supervision.

With ultra transparency, no longer are each nation's financial regulators dependent on the other nations' financial regulators to assess and communicate what is going on in the banks and bank subsidiaries hosted in their countries.

With ultra transparency, each nation's financial regulators have access to all the information.  They can both independently assess this information themselves and tap the market's ability to assess this information.  As a result, each nation's financial regulators can exert discipline on all the other nation's financial regulators when it comes to bank supervision.