Europe needs a genuine solution to bank solvency problem

As we approach five years since the beginning of the global bank solvency led financial crisis, Europe has reached the point where it needs a genuine solution to the bank solvency problem.

The Japanese model that was adopted at the beginning of the crisis is not a solution.  Unless of course one considers kicking the problem into the future and praying for a miracle a solution.

Attached to this non-solution are a host of harmful side effects.  These include, but are not limited to,

• zero interest rate policies (destroys capital markets by intentionally disrupting information on pricing in bond markets),

• bank bailouts (destroys social contract as austerity is adopted and social programs cut to cover the cost of the debt incurred to maintain the fiction of positive book capital levels), and

• regulatory forbearance (destroys real economy by cutting credit to productive uses and instead channeling it to borrowers who cannot repay debt).

Fortunately, there is an alternative to the Japanese model that has few, if any, harmful side effects (unless of course you consider reducing banker bonuses and paying them in stock harmful).  Specifically, there is the Swedish model.

Under this model, the issue of bank solvency is addressed today.  Even better, under this model the issue of bank solvency is addressed in a manner that takes advantage of how a modern banking system is designed.

Simply, Wall Street rescues Main Street.  It does this by having the banks recognize the losses on all the excess debt in the financial system today.  Subsequently, banks rebuild their book capital levels through retention of future earnings and payments of banker bonuses in stock.

With its deposit guarantees and access to unlimited central bank funding, a modern banking system is designed to absorb the losses on the excess debt in the financial system.  This design combined with ultra transparency allows banks to operate for years and supply the credit the real economy needs even while they have negative book capital levels.

Benefits of the Swedish model combined with ultra transparency incude, but are not limited to,

• stops regulatory forbearance (real economy revives because credit and assets are channeled to productive uses),

• breaks link between sovereign credit and banks (protects social contract as sovereign's resources are channeled towards promoting growth and maintaining social programs),

• ends zero interest rate policies (capital markets restart as means for allocating capital to its best uses as distortion in bond pricing disappears), and

• brings market discipline to financial sector (ultra transparency provides market participants with the information they need to independently assess the risk of each financial institution and exert discipline to restrain risk taking by adjusting the amount and price of their exposure to reflect the result of that risk assessment).

A Wall Street Journal article looked at Europe's need for a genuine solution.

Confidence in the European banking system is crumbling. Last week, Spanish and Greek authorities both had to deny reports of a run on their banks... Bank runs are the nightmare endgame for the euro crisis since there is little policy makers could do to tackle the situation.... 

Restoring confidence in the banking system is therefore the most urgent priority facing euro-zone leaders. 

What can be done?

Adopt the Swedish model and ultra transparency.

As regular readers know, it is transparency that is the key to restoring confidence.  It is only when market participants can independently assess on an on-going basis all the current asset, liability and off-balance sheet exposure details that they will have confidence in the result.  It is their confidence in the result that restores confidence in the banking system.

Greece aside, Spain is now the front line. The market is in broad agreement the Spanish banking system requires an equity injection of between €50 billion to €100 billion ($64 billion to $128 billion). 

So far, Madrid has been in denial about the scale of the problem: With the exception of Bankia SA, which has been nationalized, no major bank expects to raise equity to meet the government's latest demands for further write-downs of real-estate loans. 

But things may be changing: a deep-dive review of bank balance sheets by two government-appointed independent consultancies may identify further capital needs. The market will also scrutinize decisions taken over Bankia for clues about capital holes at other banks.

Your humble blogger previously discussed, expected losses in the Spanish banking system are 380 billion euros.  This implies the hole in the capital accounts is significantly greater than 50 to 100 billion euros.

The reason that the Spanish government focuses on 50 to 100 billion euros is this is what it might be able to raise on its own without tapping the IMF or European Stability Mechanism.

Of course, simply abandoning the already discredited Japanese model and adopting the Swedish model eliminates the need for bailing out the banks in the first place.

But it isn't just how much capital but who provides it.

THE BANKS.  They do this through retention of future earnings and payment of banker bonuses in stock.

Responsibility for bailing out banks currently resides with member states.

A fallacy that is necessary for ongoing implementation of the Japanese model.

Governments that can't borrow from markets can tap euro-zone bailout funds.... 

Once a country taps bailout funds, it is very hard to regain market access. Greece needed a second bailout; Portugal and Ireland may yet need further help. 

And once a government loses market access, the banks are shut out too—a particular worry for Spain, where there is a €545 billion shortfall in deposits to fund outstanding bank loans. A relatively small bailout for Spain's banks could turn into a giant bailout for the Spanish government and banks over many years.

The euro zone can't afford to take this risk. It needs to break the link between sovereign and bank solvency. Instead, everything it does reinforces the link, causing the European financial system to fragment along national lines: the only buyers of peripheral sovereign bonds are domestic institutions; cross-border lending has evaporated, the interbank market has shut down....

Please re-read the highlighted text because it lays out why the only viable solution for Europe is to abandon the Japanese model and adopt the Swedish model with ultra transparency.