Thursday, May 17, 2012

EU contingency plan: ECB + the Swedish model + FDIC like backstop + ultra transparency

A consensus is forming on the basic elements of the EU's contingency plan.  Besides reliance on the ECB, these include adoption of the Swedish model to clean up the banks, a system of pan-European deposit guarantees, and transparency so that the disinfectant of sunlight can be shown in all the opaque corners of the financial system.

If this sounds a lot like the blueprint for saving the financial system put forward by your humble blogger, it is because it strongly resembles the blueprint.

Regular readers will recall that under my blueprint, the EU adopts the Swedish model for handling a bank solvency led financial crisis.

Under this model, the banks recognize the losses on all the excesses in the financial system.  Recognition means that every loan is written down to a level that reflects the borrower's capacity to repay.  Not only does this relieve the real economy of the burden of carrying the excess debt, but it re-establishes collateral values so that creditworthy borrowers can access bank financing again.

In addition, the EU uses the European Financial Stability Fund and the European Stability Mechanism as a backstop for the sovereign deposit guarantees.  This virtually eliminates the possibility of a run on the banks while breaking the linkage between banks and sovereigns.

At the same time, the ECB provides secured funding to the the banks.  This assures the banks of access to funds so the banks can continue to make loans and support the real economy.

Finally, the EU requires the banks to provide ultra transparency on an on-going basis and disclose their current asset, liability and off-balance sheet exposure details.  This provides market participants with the information they need to assess that all the losses on and off the bank balance sheets have been realized.

This also puts into place the necessary sunlight so that the risk taking of banks is constrained by market discipline.  It also eliminates the need for the governments to recapitalize the banks today and allows the banks to rebuild their book capital levels from retention of future earnings.

In his Telegraph blog, Ambrose Evans-Pritchard discusses what he thinks will happen if Greece leaves the EU.
The ECB would cut rates, launch quantitative easing, blitz euroland with liquidity, and drive down Club Med yields with mass bond purchases. There may be a Swedish-style nationalisation of the banks accompanied by EMU-wide deposit guarantees.
In his Wall Street Journal Heard on the Street column, Simon Nixon looks at what he thinks will happen if Greece leaves the EU.
Nobody believes the current bailout funds—capped at €700 billion ($891.1 billion)—are anywhere near big enough to impress the markets, so the decisive crisis response will fall upon the European Central Bank. 
To head off a possible run on peripheral European banks, it would need to offer to provide unlimited liquidity—and since many banks are already short of eligible collateral, it would have to do so with very little security. That will expose the ECB—and by extension, European taxpayers—to credit risk.... 
Meanwhile the euro zone's bailout funds—the European Financial Stability Facility and European Stability Mechanism—should be used to recapitalize banks directly, rather than channeling funds via national governments. 
Given the added strain from a Greek exit on peripheral banking systems, major bank bailouts are inevitable. This has to be done in a way that breaks the link between sovereign and bank solvency if countries such as Italy and Spain are to have any chance of retaining market access.
When the Telegraph and the WSJ are discussing the central elements of the blueprint for saving the financial system, it is a sign of an idea whose time has come.

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